Briefly discuss the concept of relevant cash flows when evaluating a new project
When evaluating a new project, it is crucial to consider the concept of relevant cash flows. Relevant cash flows are the cash inflows and outflows that are directly associated with the project and can impact the project's profitability and value. These cash flows are future cash flows and can be used to determine whether a project is economically viable or not.
To identify the relevant cash flows of a new project, you need to consider the following:
1. Incremental cash flows: Relevant cash flows should focus on the incremental or additional cash flows that the project generates. This means you should compare the cash flows with and without the project to determine the project's impact.
2. Sunk costs: Sunk costs are the costs already incurred and cannot be recovered, irrespective of whether the project is undertaken or not. Sunk costs are not considered relevant cash flows as they are not impacted by the project.
3. Opportunity costs: Opportunity costs are the benefits or cash flows that are foregone by choosing one project over another. These costs represent the value of the next best alternative and should be included in the analysis of relevant cash flows.
4. Working capital: Changes in working capital, such as inventory, accounts receivable, and accounts payable, should be considered as they affect the project's cash flows. Increases or decreases in working capital represent cash outflows or inflows respectively.
5. Externalities: Externalities refer to the offshoot effects of a project that impact cash flows. These may include benefits or costs to other projects or the overall business. Evaluating these externalities can help capture the true value of the project.
By considering and analyzing these factors, you can identify the relevant cash flows associated with a new project. These cash flows are critical in determining the profitability, viability, and potential value of the project.