Question

A company is considering a proposed new plant that would increase productive capacity. Which of the following statements is correct?a. Since depreciation is a noncash expense, the firm does not need to deal with depreciation when calculating the operating cash flows.b. When estimating the project's operating cash flows, it is important to include any opportunity costs and sunk costs, but the firm should ignore cash flow effects of externalities since they are accounted for in the discounting process.c. Capital budgeting decisions should be based on BEFORE-TAX cash flows.d. In calculating the project's operating cash flows, the firm should NOT deduct financing costs such as interest expense, because financing costs are accounted for by discounting at the WACC. If interest were deducted when estimating cash flows, it would in effect be 'double-counted.

Answer 1

a. Since depreciation is a non-cash expense, the firm does not need to deal with depreciation when calculating the operating cash flows.

Step-by-step explanation:

As we know depreciation does not involve any outflow of cash it is not considered while making any decision for any investment.

As her the projects cost will be initial outlay or the initial cash outflow of the project, further any cash received from sale of products through this project shall be discounted each year to current present value, for which depreciation is not considered but all the incremental costs like interest, repair and maintenance shall be considered.

Also after tax effect is considered as this involves cash outflow in terms of tax.

With the above reasoning we conclude that for evaluating project we use NPV method and correct statement therefore is

a. Since depreciation is a non-cash expense, the firm does not need to deal with depreciation when calculating the operating cash flows.