Introduction to Finance

Sunk Costs.
A 
sunk cost
is a project-related expense that does not depend on whether or 
not the project is undertaken. For example, assume a fi rm commissioned and paid for a feasib-
ility study for a project last year. The funds for the study have been committed and spent. The 
study’s cost is not an incremental cash fl ow as it is not aff ected by the fi rm’s future decision 
to pursue or abandon the project. Therefore, the cost must be excluded from the project’s cash 
fl ow estimates.
Financing Costs.
It may seem important to account for fi nancing cash fl ows such as 
interest and loan repayments, but a good reason exists for excluding them from cash fl ow 
estimates. When cash fl ows are discounted—as in the NPV, IRR, MIRR, and PI methods—
the project’s cost of fi nancing is refl ected in the choice of the discount rate. As we shall 
discuss in more detail in Chapter 18, a project’s minimum required rate of return, or cost of 
capital, incorporates a project’s fi nancing costs. Including fi nancing costs in the cash fl ows 
and discounting them at the project’s cost of capital would result in a double counting of 
the fi nancing costs.
Approaches to Estimating Project Cash Flows 
As an initial step of the fi nancial analysis of a capital budgeting proposal, we should construct 
year-by-year projected balance sheets and income statements for the project. Analysis of these 
forecasted statements tell us what the expected cash fl ows from the project will be. Changes 
over time in the project’s working capital requirements or investment needs will represent the 
project’s cash infl ows or outfl ows. Similarly, the net income and noncash expenses from the 
project are part of the project’s periodic cash fl ows.
As was discussed in Chapter 13, one of the fi nancial statements that must be issued by 
public fi rms is the statement of cash fl ows. Here, we use the format of the statement of cash 
fl ows to identify the periodic cash fl ows of a capital budgeting project.
Recall that a fi rm’s statement of cash fl ows has three sections. The fi rst section, cash fl ows 
from operations, reports on cash generated by the fi rm’s day-to-day manufacturing and mar-
keting activities. The second section, cash fl ows from investments, usually involves data for 
investments in subsidiaries or the fi rm’s plant and equipment. The third section lists the fi rm’s 
fi nancing cash fl ows, including sales and purchases of debt as well as dividend payments.
Using this format for a capital budgeting project, cash fl ows from operations summarizes 
the sources of a project’s operating cash fl ows. Cash fl ows from investing activities report a 
fi rm’s fi xed-asset investments in the capital budgeting project. As explained earlier, cash fl ows 
from fi nancing activities are excluded from a project’s cash fl ow analysis since their impact is 
measured in the discount rate or cost of capital used to discount a project’s cash fl ow.
Table 17.5
summarizes the similarities between company and project cash fl ow state-
ments. The following sections explore these relationships in more detail.