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Capital Budgeting Concepts

1) Define the following terms:
a) Sunk Cost
b) Opportunity cost
c) Allocated cost

2) Is the following statement true or false. If the statement is true, where or how are these costs reflected?
"Financing costs should be ignored when estimating a project's relevant cash flows."

3) List and discuss items included in a project's initial cash outflow.

4) List and discuss items included in a project's terminal cash flow.

5) Williams Company is evaluating a project requiring a capital expenditure of $400,000. The project has an estimated life of 4 years and no salvage value. The estimated net income and net cash flow from the project are as follows:

Year Net Income Net Cash Flow
1 $ 90,000 $ 250,000
2 80,000 200,000
3 40,000 100,000
4 30,000 100,000
$240,000 $650,000

The company's minimum desired rate of return for net present value analysis is 10%.

Calculate the Net Present Value of the project. Should the company go forward?

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Solution Preview

1) Define the following terms:
What are sunk costs?
In economics and in business decision-making, sunk costs are costs that have already been incurred and which cannot be recovered to any significant degree. Sunk cost should not be considered in analyzing the capital budgeting project. For example market research to undertake the project or not.
What are opportunity costs?
The opportunity cost or alternative costs are the returns from the second best use of the organization's resources or here in this case the individual's capability.
For example a farmer who is producing wheat can also produce potatoes with the same factors.
Therefore the opportunity cost of a quintal of wheat is the amount of output of potatoes given up. In Economics, The opportunity cost of anything ...

Solution Summary

This solution explains various capital budgeting concepts such as sunk cost, opportunity cost, initial cash outflow, inflow, NPV and net present value with the help of examples.