Investment appraisal: not – relevant cash flows (costs)

@enes78

Well you have to look at the basic definition of a relevant cost – it is an incremental future cost that directly occurs as a result of undertaking a project.

So in the question you will have to see if a cost that is being incurred has only come about because of the project then it is a relevant cost. The cost could be variable or it could even be fixed. Once it is occurring only because you decide to undertake the project then it is relevant. It could be a completely new cost eg. cost of equipment hired to construct a new building or it could be an incremental cost eg. the additional cost of direct materials.

You always have to analyse the cost against the basic definition (as given above).

This is how I work out relevant cashflows for myself.

Relevant cash flows should be FUTURE INCREMENTAL CASHFLOWS.

1) Future – the cashflows have to arise in future, if they have already been incurred, then they are sunk costs and are not relevant

2) Incremental – cashflows have to arise as a result of undertaking the project, say if Fixed costs at $10,000 were supposed to be incurred anyway and as a result of undertaking the project they are still $10,000 – they this is not incremental cashflow, therefore not relevant. But if say as a result of undertaking project Fixed costs will increase to $12,000 (stepped cost) – then the extra $2,000 will be incremental cashflow.

3) Cashflows – it has to be a cashflow, so non-cash elements like depreciation are not relevant.

For cashflow to be considered relevant – it has to pass all of the above 3 tests, if it doesn’t pass at least one test – then it’s non-relevant.