In capital budgeting, which cash flows should be included in the analysis?

• A. Sunk costs
• B. Historical costs
• C. Incremental cash flows
• D. All costs including non-relevant

Answer: (C)

In capital budgeting, the key idea is to focus on incremental cash flows—the changes in cash that occur because you undertake the project versus if you do nothing. Only those cash flows matter because they directly affect the project’s value. Include the initial outlay, the expected incremental operating cash inflows and outflows, any changes in working capital, and any terminal or salvage cash flows. Sunk costs have already happened and cannot be recovered, so they don’t influence future decisions and should be ignored. Historical costs aren’t relevant to future choices, either, for the same reason. Not all costs are relevant: if a cost would occur anyway regardless of the project, it should not be counted in the analysis. Depreciation, while not a cash outlay, affects taxes and thus the after-tax incremental cash flow, so its tax shield should be reflected in the calculation.