Question

3. Identifying incremental cash flows Aa Aa E 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: The project's fixed-asset expenditures Changes in net working capital associated with the project The project's depreciation expense The project's financing costs 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. 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 column, indicate whether the item should be included in the project's analysis or not. Sunk Cost Opportunity Cost Change in NWC Include in the Analysis? Cannibalization 0 The new project is expected to reduce sales revenue for one of the company's other product lines. The project will use some equipment that the firm owns but isn't using currently. However, a used-equipment dealer has offered to buy the equipment. Bumbly spent nearly $1.1 million in market research to develop new product ideas. Many of the new sales from this project will be made on credit, causing accounts receivable to increase. 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). Oo oo 0 0 0

Answer 1

As per rules I am answering the first 4 subparts of the question

1: Option 4

The financing cost of the project are not considered incremental cash flows but accounted for in the discount rate. Fixed asset expense and working capital are incremental cash flows. Depreciation expense creates a tax shield and hence it is an incremental cash flow.

2: Erosion cost /Cannibalization

Erosion cost represents the loss of sales and revenue due to undertaking the project and must be taken into account in capital budgeting analysis.

3: Cannibalization, Include in analysis

This represents the loss of sales and revenue due to undertaking the project and must be taken into account in capital budgeting analysis.

4: opportunity cost,Include in analysis

The business has the option to sell the asset which will be lost if the project is undertaken.