Friday, May 28, 2010


Additional Aspects of Incremental Cash Flow Analysis
  • Opportunity costs of resources

Sometimes a proposed investment project may use the existing resources of the firm for which explicit, or adequate, cash outlays may not exist. The opportunity cost of such projects should be considered. Opportunity costs are the expected benefits, which the company would have derived from those resources if they were not committed to the project.

Assume, for example, that the company is considering a project, which requires 7000 cubic area. Also suppose that the firm has 10000 cubic feet area available. What is the cost of the area available within the firm if it is used by the project? One answer could be that since no cash outlay is involved, therefore, no charges should be made to the project. But from the point of the alternative investment opportunity foregone by transferring this available area to the project, it seems desirable to charge the opportunity cost of the area to the project. Suppose that the company could rent the area at 18$ per cubic feet, and then 126000$ should be considered as the opportunity cost of using the area. The opportunity cost of the other resources can also be computed in the same manner. It may be sometimes difficult to estimate opportunity cost. If the resources can be sold, its opportunity cost is equal to the market price. It is important to note that the alternative use rule is a corollary of the incremental cash flow rule.

  • Incidental effects

An investment project under consideration may influence the cash flow of other investment opportunities, or the existing projects or products. The incremental cash flow rule applies here; it tells us to identify all cash flows, direct or incidental, occurring as a result of the acceptance of an investment opportunity. It is, therefore, important to note that all incidental effects, in terms of cash flows, should be considered in the evaluation of an investment opportunity.

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