Question

Explain the difference between opportunity cost, the stand alone principle, and erosion.  

When determining cash flows is there one of these that is most important? Why or why not?

Answer 1

Opportunity cost:

Opportunity cost is defined as sacrifice that is made in order to achieve something else. Resources like land; money etc. can be used in alternative ways. Hence every action or choice has opportunity cost associated with it.

Opportunity cost is defined as fundamental cost in economics and is used in computing the cost benefit analysis made on a project. These costs are not recorded in account books like other costs and are used only for decision making purpose by calculating the outflows of cash and the profit or loss arising as a result.

Stand alone principle:

Stand alone principle is a principle that business makes decisions to accept or decline a project by comparing it with securities of same class. In this case, project is evaluated based on its own merits. The project has its:

• Future costs and revenues.
• Cash flows
• Assets.

Erosion:

Erosion can be defined as new project cash flows that arise at the expense of other projects. For example, we can consider a new product line which takes the cash flows of the product line that already exists. Cash flows are considered to be relevant only if it doesn’t lose the competition or the existing product line.

Which is more important in determining the cash flows?

Relevant cash flows are those cash flows that arise as a result of cash flow from erosion effects and cash flows from opportunity cots.

Hence erosion and opportunity costs are important for determining the cash flows.