1. Which of the following rules is correct for capital budgeting analysis?
The interest paid on funds borrowed to finance a project must be included in the project’s estimated cash flows.
If a product is competitive with some of the firm’s other products, this fact should be incorporated into the estimate of the relevant cash flows. However, if the new product is complementary to some of the firm’s other products, this will have no effect on the cash flows used in the analysis.
Sunk costs are not included in the annual cash flows, but they must be deducted from the PV of the project’s other costs when reaching the accept/reject decision.
Only incremental cash flows are relevant when making accept/reject decisions.
2. Laurier Inc., a household products firm, is considering production of a new detergent. In evaluating whether to go ahead with the project, which of the following items should NOT be explicitly considered when cash flows are estimated?
The project will utilize some equipment the company currently owns but is not now using. A used-equipment dealer has offered to buy the equipment.
The new detergent will cut into sales of the firm’s other detergents.
The company will produce the detergent in a vacant building that was used to produce another product until last year. The building could be sold, leased to another company, or used in the future to produce other Laurier products.
The company has spent and expensed for tax purposes $3 million on research related to the new detergent. These funds cannot be recovered, but the research is expected to benefit other projects that might be proposed in the future.