CAT / FIA FMA Syllabus D. Budgeting - Relevant cash flows - Notes ^{7 / 10}

What are they?

Relevant costs are those whose inclusion affects the investment decision.

The cash flows that should be included in a capital budgeting analysis are those that will only occur if the project is accepted.

You should always ask yourself “Will this cash flow change ONLY if we accept the project?”

– If the answer is “yes,” it should be included in the analysis because it is incremental

Hence, the only cash flows that should be taken into consideration in capital investment appraisal are:

• Future costs (ignore past / sunk costs)

  For example if money has already been spent on research and development, that should be ignored, only if the money has not been spent yet, then it is relevant.

• Incremental cost

  For example if our new production can be carried on in the same factory, then there is no increase in the rental cost, so rent should be ignored, but if we have to hire a new space for production, then the rental cost of the new space is relevant. 

  Other examples of relevant incremental costs include repair costs arising from use, hire charges and any fall in the resale value of owned assets which results from their use.

• Cash 

  For example depreciation of machines is not cash and should be ignored.

• An opportunity cost (the value of a benefit foregone a result of choosing a particular course of action) is always a relevant cost.

  For example if our investment decision results in another product not being produced and sold, then the contribution foregone because the other product cannot be produced is relevant.

Note that the interest/finance cost at the cost of capital is not relevant, this is because the investment appraisal techniques already account for this.