How do we determine if cash flows are relevant to the capital budgeting decision?
Any cash flows that are not incremental are not useful, and also are not used for decision in the capital budgeting. All investments are expected to earn a return that can be evaluated by comparing the future cash outflows and cash inflows. When dealing with capital budgeting decisions, the concept of incremental cash flow is central to the firm’s analysis. The incremental cash flows determine the difference between a firm’s future cash flows with a project and those without a project.
In the context of capital budgeting, what is an opportunity cost? Opportunity cost is defined as the benefit surrendered from a specific decision. When a firm is undertaken an investment, the most valuable alternative that is given up is called an opportunity cost. In the context of capital budgeting, an opportunity cost is the value of an asset that will be used in the project.