Question

Which of the following are relevant cash flows in the evaluation of a proposal to produce a new product?

1. Decrease in the cash flows of a substitute product.

2. Salvage value of the new machine at the end of its useful life.

3. Cost to develop a product prototype last year.

4. Increase in net working capital at the beginning of the project’s life.

5. The cost of a new machine required to produce this product.

6. Alternative of leasing an existing building that will be used for manufacturing this product.

Answer 1

While producing a new product, we need to take incremental revenue and incremental cost

1) Incremental revenue = Total Revenue with the new product - Total Revenue without the new product

Since, decrease in cash flows of a substitute product will impact the total revenue with the new product. It is a relevant cash flow.

2) Relevant, Without the new product, there would be no need of the new machine, so there would be no salvage value if the new product is not introduced.

3) Not relevant, Cost to develop a product prototype last year is a sunk cost. Sunk costs are not included since deciding now whether to introduce the product or not will not change the costs already incurred.

4) Relevant. Increase in working capital is incremental cost and there would be no increase in working capital if the new product is not introduced.

5) Relevant. The cost of a new machine required to produce this product and is an incremental cost because there would be no need of new machine if the new product is not introduced.

6) Relevant, This is an incremental cost and would not incur if the product is not introduced.