Explain the major differences between cash flows for replace

Explain the major differences between cash flows for replacement (cost cutting) projects versus cash flows for expansion projects.

What are substitutionary and complementary effects in the context of capital budgeting cash flow analysis? Give an example of each.  

What are opportunity costs in cash flow analysis

Solution

We can think of various examples for replacement project. To start with simple example, we use rate cutter scheme to cut our base call or data cost. In which we are spending or investing extra cost to reduce the day to day cost. To think in industry perspective, if a machine is requiring huge manual effort to operate it and maintanence cost is also huge. We can replace with a higher efficient machine which require less man power to operate and less maintanence cost. Here the new machine is a new project to invest to reduce the already existing cost. But the opportunity cost here is the old machines doesnt have any resale value and the cost of old mmachine using is also an opportunity cost to give up.

Expansion project is like acquiring a new company or to just launch a new product. If a shampoo company also decides to sell soaps, then it\'s a expansion project and here the cost/expense in the cash flow increases. It doesn\'t decrease as we saw in cost cutting projects. Here in the expansion project, the profit also increases as the sales will be high when both shampoo and soaps are sold. There is not much opportunity cost here. To reduce the labour cost, if we are manufacturing the soaps in cheap labour country, then the travel cost is also included and this will reduce the revenue. This is the opportunity cost but it can be replaced with the lesser labour cost.

To explain in short, the replacement/cost cutting project increases profit by reducing the cost. And the expansion project, both the cost and profit increases simultaneously.