Question

Question 7 (10 marks] 7.1. 7.2. Operating cash flows, rather than accounting profits, are used in project analysis. What is the basis for this emphasis on cash flows as opposed to net income? (4) Why is it true, in general, that a failure to adjust expected cash flows for expected inflation biases the calculated NPV downward? (2) Explain why sunk costs should not be included in a capital budgeting analysis but opportunity costs and externalities should be included. 7.3.

Answer 1

7.1

Operating cash flows give a clear picture of the returns generated by a project. They are also free of manipulation which can be done with accounting manipulation. Operating Cash Flows also take into account Working Capital changes. Thus using Operating Cash Flows gives a clearer picture when calculating NPV.

7.2

Not adjusting for inflation would result in underestimating the cash flows from a project. The cost of capital used to discount the cash flows already considers the effect of inflation. Hence ignoring inflation would result in a smaller cash flow and hence reducing the NPV.

7.3

Sunk cost should not be included in the project cost because regardless of the decision to accept or reject the project this costs have to be borne.

Externalities and opportunity costs have to be considered because they affect the cash flow resulting from the project.

For e.g. A company is planning to launch a new product. This new product is likely to reduce the sales of an existing product. This reduction happens due to the new product and hence when considering the product's financial viability it needs to be taken into account as it the cash flow addition needs to be considered for the company as a whole.