Making Capital Investment Decisions

Question 1

Sunk Costs

Answer 1

A sunk cost is a cost that has already occurred. Because sunk costs are in the past, they cannot be changed by the decision to accept or reject the project. As we “let bygones be bygones,” we should ignore such costs. Sunk costs are not incremental cash outflows.

Question 2

Opportunity Costs

Answer 2

Your firm may have an asset that it is considering selling, leasing, or employing elsewhere in the business. If the asset is used in a new project, potential cash flows from alternative uses are lost. These lost cash flows can meaningfully be viewed as costs. They are called opportunity costs because, by taking the project, the firm forgoes other opportunities for using the assets.

Question 3

Allocated Costs

Answer 3

Frequently a particular expenditure benefits a number of projects. Accountants allocate this cost across the different projects when determining income. However, for capital budgeting purposes, this allocated cost should be viewed as a cash outflow of a project only if it is an incremental cost of the project.

Question 4

Alternate Definitions of operating cash flows.

Answer 4

top-down approach because we start at the top of the income statement and work our way down to cash flow by subtracting costs, taxes, and other expenses.
This is the bottom-up approach, whether written as Equation 6.4 or Equation 6.4′. Here we start with the accountants’ bottom line (net income) and add back any noncash deductions such as depreciation. It is crucial to remember that this definition of operating cash flow as net income plus depreciation is correct only if there is no interest expense subtracted in the calculation of net income.
The tax shield approach is a variant of the top-down approach,
This part is depreciation flow is $632. approach what the expense. views OCF as having project’s cash flow In our example, two components. The would be if there were this would-have-been first no cash The second part of OCF in this approach is the depreciation deduction multiplied by the tax rate. This is called the depreciation tax shield . We know that depreciation is a noncash expense. The only cash flow effect of deducting depreciation is to reduce our taxes, a benefit to us.