Question

W. Ibr Engineers 12. Tou are provided a chart representing the cash flows expected from a coffee a retail store. You remember from your finance course that only incrementa included in the chart as relevant items for capital budgeting decision. When you examine the chart, you have noted the following points. a. Comment on each as relevant or not and, b. briefly explain why in one or two sentences. nber from he the cash flo expected from a coffee shop project in ance course that only incremental cash flows (10p) the coffee shop project chart includes expected revenue increase in retail store due to opening of the planned coffee shop. The retail store owner first wanted to initiate this project two years ago and spent 100.000 Lira for a market research and feasibility report. The invoice is already paid. The chart includes this item as initial Cash Outflow. The project uses an empty corner in the retail store. The space is currently not rented to anyone, thus no income is generated. However, it is estimated that 2.000 Lira rental income could be generated if rented. The chart includes this figure as cash outflow. 50% of the project's initial outlay will be financed by bank loan. The chart includes the costs (interest) of this loan. The current overhead costs for the retail store (electricity, heating, security, etc.) is 5.000 Lira per month. The new project will not cause an increase in these costs. However, since 20% of the store space will be allocated for the coffee shop project, the accountant decides to allocate 1.000 TL (20%) of the said expenses to the new project, once it starts to operate. These expenses are included in the chart as cash outflow.

Answer 1

• The expected increase in the revenue of the retail store is relevant because coffee shop project has led to overall increase in the revenue of the retail store. Without the coffee shop there would be no increment in revenue. However the coffee shop has generated additional revenue for retail store, it is relevant for capital budgeting.
• The market research and feasibility study costs are not relevant because these costs are sunk costs. These amount is already gone whether the project is undertaken or not. Hence these costs are not considered for capital budgeting.
• The 2000 lira rental income which can be generated if rented are the opportunity costs. These outflows are relevant for the capital budgeting as 2000 lira might have been earned if the coffee shop was not opened in the store.
• When evaluating a capital budgeting decision, we do not include interest expenses. Interest expenses are related to the firm´s decision regarding how to finance the project, but we only want to evaluate the project on its own, separate from the financing decision. Hence interest expense are not relevant.
• The overhead costs are going to remain 5000 lira in the future irrespective of opening of coffee shop. So it is not relevant to include 1000 lira in calculation.