The determination of cash flows, the relevant aspects of a project start with a question: do the future cash inflows or outflows for the company change as a direct consequence of the realization of the project? An affirmative answer means that the flow is relevant, otherwise it is irrelevant. Since the relevant cash flows are related to changes in cash flows for the company, these flows are also known as incremental cash flows. Put another way: the incremental or relevant cash flows are those that generate some change in the cash flows of the company. Therefore, all incremental cash inflows and outflows – positive and negative – must be taken into account as part of the cash flows related to the project.
To evaluate the project, only incremental cash flows are considered. It is not necessary to calculate the total cash flows of the company with the project and without it; the incremental cash flows of the project are simply taken into account in a particular way. This condition is known as the principle of individuality. What the principle of individuality suggests is to manage the project as if it were a separate business; with its own income, expenses, initial investment and cash flows; that is, an independent business of the company that will carry it out.
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A sunk cost is one that has already been incurred regardless of whether the project is carried out or not, so it is not relevant for decision making, so it must be suppressed in the analysis and valuation of a project. This definition is apparently too obvious and simple to understand and apply when evaluating a project, but before making your conclusions consider the following examples. Suppose Compotators GL hires a marketing agency to conduct a market study in order to establish acceptance of a new model of laptop. The financial analysts of the company insist that the cost of the study should be included as part of the initial investment to carry out the project. Are you correct? The answer is no”. Regardless of whether the market study is conducted and whether or not the new computer manufacturing project is carried out, the agency that carried out the study charges a fee for its work; this fee is a sunk cost.
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Moreover, imagine that several months ago a furniture manufacturer contracted a specialist company to maintain a property owned by the company. At this moment it is being considered to use that land to build a new warehouse. Once again, the money that was used to fix the land is a sunk cost because, regardless of whether the warehouse is built or not, those resources have already been disbursed.
A cost is not just an outlay of money to make a payment. A cost may also be not receiving any benefit. These costs are known as opportunity costs. Opportunity costs are presented in investment projects when the company must use certain resources that it already has to carry out said project. For example, imagine that a company has a building that was used as a warehouse some years ago, but is now empty. Due to its location and other characteristics, it is now considering the possibility of upgrading the old warehouse to use it as a showroom for the company’s products, which would require a relatively small investment.
Of course, if the project is carried out, there would be no disbursement of cash for the purchase or construction of a new building, since one already has one. However, the use of the building is not free since it would be using a valuable resource that is already in the project of the exhibition room. Even if the company is not using it for its operations and could not use it in the future, the building could be sold. Consequently, the use of the warehouse to convert it into an exhibition hall represents an opportunity cost; which is a relevant cost that should be considered when evaluating the new project. Suppose now that the warehouse building had an original cost of $ 500,000 and that due to its ageist has a book value of $ 200,000. Should the $ 500,000 or $ 200,000 be considered as the opportunity cost of this building? Actually none of these two amounts should be taken as the opportunity cost. The $ 500,000 originally paid for the building is a sunk cost, while the $ 200,000 is only a book value for registration and other purposes. The real opportunity cost of the building would be the market value that would be obtained if it were sold at this time.
Let’s consider one last case. Imagine that the building is being leased to another company that uses it as a warehouse. If the project to condition the old warehouse is carried outgas a showroom the building would be left to rent and, therefore, the income received for this concept would no longer be obtained. This money not perceived would, of course, be an opportunity cost that should be considered.