101 Concepts for the Level I Exam

Concept 59: Basic Principles of Capital Budgeting

Decisions should be based on incremental cash flows (not on accounting income as it is based on accrual basis):

Exclude sunk costs

For example, already incurred costs like preliminary consulting fees should not be included in the analysis.

Include externalities – Both positive/negative externalities should be considered in the analysis.

For example, negative impact of a new diet soda product launch on the sales of existing soda products.

(Note: In a conventional cash flow, the sign of cash flows changes only once during the life of the project; while an unconventional cash flow has more than one sign change.)

Timing of cash flows is vital: Due to time value of money, cash flows received earlier are more valuable than cash flows received later.
Cash flows are based on opportunity cost

For example, if you plan to use an existing office space rather than renting it out, then rental income from the office space is an opportunity cost.

Cash flows are analyzed on an after-tax basis: Shareholder value increases only on the cash that they have earned. Hence, any tax expenses must be deducted from the cash flows.
Financial costs are ignored: Financial costs are already included in the cost of capital (discount rates) used to discount cash flows to arrive at the present value. Hence, to avoid double-counting, they must not be deducted from the project’s cash flows.