Q1) How should “allocated” and “direct” overheads be treated in an investment evaluation?
Give reasons for your answer. (4 marks)

Q2. What are sunk costs? Explain with examples. Are they relevant in evaluating a project? Why
or why not? (4 marks)

Q3. What are “incidental impact” or “cannibalization effect”? Explain their impact on a project’s
cashflows with examples. (4 marks)

Q4. What are the risks of
i) excessive working capital; and
ii) inadequate working capital?
How would each of these impact the performance of an entity? (4 marks)

Q1. How should “allocated” and “direct” overheads be treated in an investment evaluation?
Ans: Allocated overheads should be ignored while evaluating an investment because they are incurred regardless of the investment. On the other direct overheads are incurred only if the investment is made and hence are directly related to the investment and should be considered while evaluating an investment.

Q2. What are sunk costs? Explain with examples. Are they relevant in evaluating a project? Why or why not?

Ans: Sunk costs are costs which have already been incurred prior to evaluation of a project. For example, consultant fees paid to conduct market study for a new product. The costs have already been incurred and will not have impact whether the project is accepted or rejected, Hence, they are not relevant in evaluating a project.

Q3. What are “incidental impact” or “cannibalization effect”? Explain their impact on a project’s cashflows with examples.

Ans: Incidental impact is unplanned and unforeseen impacts of a project which had not been foreseen earlier. Cannibalization effect is the loss in sales of an existing product due to launch of a new product. For example a company launches a new mobile phone X1. Due to launch of X1, the sales of its existing phone A1 decrease by 10%. Incidental impact or cannibalization are important to be considered at the time of determining a project's cashflows because they are directly dependent on acceptance or rejection of the project and are hence relevant for decision making.

Q4. What are the risks of
i) excessive working capital: -Excessive working capital means the funds of the company are not adequately invested in profitable projects. Working capital usually does not earn any returns on its own and hence excess working capital can be considered as idle funds which lead to loss of return on investments.

ii) inadequate working capital: - The company will find it difficult to short-term liabilities and other day to day expenses in time. This will lead to inefficency in operations as the company will have to look for sources of funds to meet operational needs as and when they arise. Bad working capital ratios also make it difficult for the company to obtain debt.