A company is considering a new project. The CFO plans to calculate the project's NPV by estimating the relevant cash flows for each year of the project's life (the initial investment cost, the annual operating cash flows, and the terminal cash flow), then discounting those cash flows at the company's WACC. Which one of the following factors should the CFO include in the cash flows when estimating the relevant cash flows?
A) all interest expenses on debt used to help finance the project
B) the investment in working capital required to operate the project, even if that investment will be recovered at the end of the project's life
C) sunk costs that have been incurred relating to the project, but only if those costs were incurred prior to the current year
D) effects of the project on other divisions of the firm, but only if those effects lower the direct cash flows of the project

Question

Quizplus · Accepted Answer

The investment in working capital required to operate the project should be included in the relevant cash flows because it represents an initial investment that will be recovered at the end of the project's life. Interest expenses on debt used to help finance the project should not be included in the cash flows because they are already accounted for in the WACC used for discounting. Sunk costs that have been incurred should not be included in the cash flows because they are irrelevant to future cash flows. The effects of the project on other divisions of the firm should not be included unless they directly affect the cash flows of the project.

A Company Is Considering a New Project