Quiz 6 Bereket Desalegn Abebe F17401107

1. How do we determine if the cash flows are relevant to the capital budgeting decision?

When doing capital budgeting analysis sunk cost is not considered. A sunk cost is those costs that have
been occurred in the past and whether the project is being taken or not the sunk cost is not affected by
that. Normally the rule for consideration of any project all the cash flows which are going to occur if the
project is taken up should be considered in the decision-making process and other costs should be
ignored.

2. What are the different methods of computing operating cash flow, and when are they
important?

There are two broad methods of calculating operating cash flow, one is direct method and the other is
indirect method.

Direct method: Direct method of calculation of operating cash flow is used when you are considering
each of the cash disbursements and cash receipts. This method is useful when the disbursements are
happening on cash basis.

Indirect Method: Indirect method is used when disbursements are not happening on complete cash
basis and we calculate the operating cash flow by starting from net income and making adjustments for
working capital, capital expenditure and depreciation. This method is used mostly because
disbursement usually does not happen on fully cash basis.

3. How should cash flows and discount rates be matched when inflation is present?

In times of inflation, we should either adjust the discount rates or adjust the cash flow. When we trying
to discount the cash flows then we are using real discount rates then we should also adjust the cash
flows for inflation and when the rates being used are nominal then the cash flow need not be
discounted for inflation since the nominal rate will have already adjusted for that.

4. What is equivalent annual cost, and when should it be used?

The equivalent annual cost is the annual cost of operating machinery and it is one of the capital
budgeting methods used by firms when they have to decide which machinery to operate and how much
cost is going to be annually for them. The equivalent annual method is used to compare projects when
the projects' lives are unequal.