Question

When firms make capital budgeting decisions, they should concern themselves with incremental cash flows, not net income, when evaluating projects. To determine the incremental cash flows associated with a capital project, an analyst should include all of the following except: O Changes in net working capital associated with the project The project's financing costs The project's depreciation expense The project's fixed-asset expenditures Indirect cash flows often affect a firm's capital budgeting decisions. However, some of these indirect cash flows are relevant to capital budgeting decisions (because they represent marginal cash flows that depend on the project's acceptance), but others should be ignored. Opportunity costs represents the effect of the current project's acceptance on cash flows of the firm's other projects. Because they depend on whether the current project is accepted, they should be included in the analysis. Consider the case of Bumbly Products Inc. The company is evaluating a capital budgeting project and has come across a few issues that require special attention. Classify each item as a sunk cost, cannibalization, opportunity cost, or a change in net working capital (NWC). Then, in the last table, indicate whether the item should be included in the project's analysis or not. Sunk Cost Opportunity Cost Cannibalization Change in NWC The new project is expected to increase the company's overall sales, but it will take away some of the market share from some of its existing products. The factory that the project will use could be used for another project that is expected to have a slightly positive net present value (NPV). 0 Before finalizing on this new project, the company tested some earlier prototypes that are not being used in the current product. 0 For this new product, the company will use an aggressive selling strategy and offer 90- day credit to its customers. This will lead to an increase in accounts receivable. 0 The project will use some raw materials that the firm has in its inventory and can sell at 0 a certain price.

Answer 1

Solution:

Included Opportunity Cannibali Change in the Cost zation in NWC Analysis Yes Yes Sunk Cost The new project is expected to increase the company's overall sales, but it will take away some of the market share from some of the exiting produts The factory that the project will use could be used for another project that is expected to have slightly positive net present value (NPV). Before finalizing on this new Project, the company tested some earlier prototypes that are not being used in the current period. For this new project, the company will use an aggressive sellling strategy and offer 90-day credit to its customers. This will lead to an increase in accounts receivable. The project will use some raw materials that the firm has in its inventory and can sell at a certain price. Yes Yes

If Bumbly will issue debt then, the increase in interest expense would lower the net income, hence, it will affect the cash flows and thus, it must be included in the analysis while making the decision.