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3. Identifying incremental cash flows

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:

Changes in net working capital associated with the project

The projects financing costs

The projects depreciation expense

The projects fixed-asset expenditures

Indirect cash flows often affect a firms 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 projects acceptance), but others should be ignored.

represent the effect of the current projects acceptance on cash flows of the firms 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 projects analysis or not.

	Sunk Cost	Opportunity Cost	Cannibalization	Change in NWC
The new project is expected to increase the companys 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).
Before finalizing on this new project, the company tested some earlier prototypes that are not being used in the current product.
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.
The project will use some raw materials that the firm has in its inventory and can sell at a certain price.

	Include in the Analysis?
The new project is expected to increase the companys 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).
Before finalizing on this new project, the company tested some earlier prototypes that are not being used in the current product.
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.
The project will use some raw materials that the firm has in its inventory and can sell at a certain price.

Suppose Bumbly will be issuing debt to support this project and other capital budgeting projects this year. The firms interest expense will increase by $700,000. Should the change in interest expense be included in the analysis?

Yes

No

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