Which of the following statements describes the most appropriate treatment of cash flows in capital budgeting?
A) A project is evaluated using its incremental cash flows on an after-tax basis.
B) Interest costs are included in the project’s cash flows to reflect financing costs.
C) Sunk costs and externalities should not be included in the cash flow estimates.
The answer is A. But what about C. Shouldn’t sunk costs/eternalities not be included in cash flows
Because a sunk cost is not part of the capital budgeting process. It’s a sunk cost and should not affect your decision to undertake the project.
Yes, its not part of the capital budgeting process which is why its not part of the cash flows. Am I missing somethign? I still dont’ get why C) is incorrect
Externalities should be accounted for in your analysis, because they can impact your incremental after-tax cash flow. For example, if a project is undertaken, you will have a certain amount of incremental after-tax cash flow directly related to the project. However, there may be an inadvertent positive/negative influence on another aspect of your operations (and the cash flows for that other segment). This externality should be included in the analysis (since the incremental cash flow will be different due to the project). This isn’t a very precise example, but I think it should get the point across as to why C is incorrect (and why A is correct).
Ahh got it. Sunk costs not included but Externalities should be.
Thanks