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 factor 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 CFO should include 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. This is because the investment in working capital is a cash outflow that is needed to operate the project and should be taken into account when estimating the relevant cash flows. Options A, C, and D are incorrect. Interest expenses on debt used to finance the project should be included in the calculation of the WACC, but not in the estimation of cash flows. Sunk costs that have been incurred relating to the project should not be included in the estimation of cash flows, as they are irrelevant to future cash flows. Effects of the project on other divisions of the firm, even those that lower the direct cash flows of the project, should not be included in the estimation of cash flows for the project, as they are not relevant to the project itself.

A Company Is Considering a New Project