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Financial Management · Investment appraisal techniques

Relevant Cash Flows for Investment Appraisal in ACCA FM

Updated 11 October 2026 · Fact-checked

Relevant cash flows are the future, incremental cash flows that change because a project goes ahead. Include extra revenues, avoidable costs, opportunity costs, working capital and tax effects. Ignore sunk costs, committed costs, depreciation, allocated overheads and financing costs, because they do not change the decision or are in the discount rate.

Understand Relevant Cash Flows for Investment Appraisal

Investment appraisal asks one question: will the company be better off in cash terms if it takes the project than if it does not? So you compare two worlds and look only at the difference. A cash flow is relevant if it is future, incremental and cash.

Future means it has not happened yet. A sunk cost is already spent, such as a feasibility study paid last year. Nothing you decide now can get it back, so ignore it. A committed cost must be paid whether or not the project goes ahead, such as a contract you cannot cancel. It is also ignored.

Incremental means the cash changes because of the project. Extra staff costs, extra materials and extra variable overheads count. General overheads that would be incurred anyway do not. Only the extra overhead caused by the project counts. An opportunity cost is the cash you give up by using a resource for the project, for example the profit lost from using machine time or the sale proceeds lost by keeping an asset. It is relevant.

Cash means non-cash items are out. Depreciation is an accounting allocation, not a cash flow, so ignore it. The cash effect of buying the asset is the outlay itself. Tax is different: capital allowances reduce tax, and tax is a cash flow, so the tax saving is relevant. Interest and other financing costs are also ignored, because the cost of finance is already reflected in the discount rate. Including interest would double count it.

Working capital is relevant. An investment in inventory or receivables is a cash outflow at the start, and it is released at the end. Only the change in working capital each year is the cash flow.

Key rules to remember

Relevant cash flow test
Relevant = future + incremental + cash
If a flow fails any one of the three tests, leave it out.
Incremental cash flow
Cash flow with the project − cash flow without the project
Use this to test any doubtful item, such as overheads or lost contribution.
Working capital cash flow
Cash flow in year t = working capital needed at end of year t − working capital in place at start of year t
An increase is an outflow. A decrease is an inflow. Release the remaining balance in the final year.
Opportunity cost of a resource
If the resource would be replaced, relevant cost = replacement cost. If not, relevant cost = higher of net resale value and the net benefit from the next best use.
For a resource already owned and not needed elsewhere, use the net resale value or the lost contribution from the next best use, whichever is higher.
Tax effect of capital allowances
Tax saving = capital allowance × tax rate
Timing depends on the tax rules given in the question.

How to solve Relevant Cash Flows for Investment Appraisal questions

Use this checklist on every appraisal question. It stops you adding irrelevant items and missing relevant ones.

  1. 1List every figure in the question and mark each as revenue, cost, asset, working capital, tax or finance.
  2. 2Test each item: is it future, incremental and cash? Cross out sunk costs, committed costs, depreciation, apportioned fixed overheads and interest.
  3. 3Value each retained resource at its opportunity cost, such as lost contribution, resale value or replacement cost.
  4. 4Put each flow in the right year. Treat the initial outlay as Year 0 and annual flows as year-end unless told otherwise.
  5. 5Calculate working capital changes year by year and show the release in the final year.
  6. 6Add tax effects: tax on extra profits and tax saved by capital allowances, using the timing the question gives.
  7. 7Apply inflation if the question says so, then discount at the given rate.
  8. 8State the NPV and give a clear recommendation. Mention any items you excluded and why.

Quickest way: Three-test sweep

When to use it: Use this in Section A and Section B objective questions, where you must pick the relevant figure quickly.

  1. Ask: has this cash been spent or promised already? If yes, drop it.
  2. Ask: would this cash be the same without the project? If yes, drop it.
  3. Ask: is it a real cash flow, not depreciation, an apportioned cost or interest? If not, drop it.
  4. For what is left, check for hidden items: lost contribution, resale value, working capital and tax.
  5. Add up only the survivors and check the timing.

Common mistakes in Relevant Cash Flows for Investment Appraisal

  • Including depreciation as a cost of the project.

    Depreciation appears in profit calculations, so it looks like a cost.

    Fix: Remove it. Use the actual cash outlay at Year 0. Only capital allowances matter, and only for their tax saving.

  • Including interest or the cost of finance in the cash flows.

    Students think a loan used for the project should be shown as a cost.

    Fix: Leave financing out of the cash flows. The discount rate already reflects the required return on finance.

  • Including sunk costs such as past research or market surveys.

    The cost is linked to the project and is often given in the question.

    Fix: Ask whether the money can still be changed by the decision. If it has already been spent, ignore it.

  • Including apportioned fixed overheads.

    Absorbed overhead per unit looks like part of the cost of the product.

    Fix: Include only extra overhead that would not be incurred without the project.

  • Forgetting working capital or not releasing it at the end.

    It is not in the profit figure and is often buried in the wording.

    Fix: Show the change each year. Inflows in the final year when the balance is released.

  • Ignoring opportunity costs of assets or staff the company already owns.

    There is no new payment, so it feels free.

    Fix: Use the cash given up: resale value, lost contribution or the cost of replacement if the resource must be replaced.

Worked examples

Example 1

Ravi Ltd is considering a project. Last year it spent ₹2,00,000 on a feasibility study. The project needs a new machine costing ₹10,00,000 now. It will generate extra annual cash revenue of ₹6,00,000 and extra cash operating costs of ₹2,50,000 for three years. Depreciation of ₹3,00,000 a year and apportioned head office costs of ₹50,000 a year are charged to the project. Interest on the loan to fund it is ₹80,000 a year. Ignoring tax, and ending with the machine worthless, which annual cash flow is relevant, and what is the NPV at 10%? The 3-year annuity factor at 10% is 2.487.

Show the solution
  1. Feasibility study of ₹2,00,000: sunk, ignore.
  2. Depreciation of ₹3,00,000: non-cash, ignore.
  3. Head office costs of ₹50,000: apportioned, not incremental, ignore.
  4. Interest of ₹80,000: financing cost, in the discount rate, ignore.
  5. Annual relevant cash flow = ₹6,00,000 − ₹2,50,000 = ₹3,50,000.
  6. PV of inflows = ₹3,50,000 × 2.487 = ₹8,70,450.
  7. NPV = ₹8,70,450 − ₹10,00,000 = −₹1,29,550.

Answer: Relevant annual cash flow is ₹3,50,000. NPV is −₹1,29,550, so the project should be rejected on these figures.

Example 2

Meera Co is appraising a two-year project. It needs working capital of ₹1,00,000 at the start of Year 1, rising to ₹1,40,000 at the start of Year 2. All working capital is recovered at the end of Year 2. The company also owns a machine that it could sell now (Year 0) for ₹90,000, and the project would use it instead. The machine will have no value after two years. Discount at 10%. Show the cash flows for working capital and the machine, with discount factors Year 0 1.000, Year 1 0.909, Year 2 0.826.

Show the solution
  1. Timing rule: annual flows fall at the year end, so working capital needed at the start of a year is treated as paid at the end of the previous year.
  2. Machine: using it means losing the sale of ₹90,000 now. This opportunity cost is an outflow of ₹90,000 at Year 0.
  3. Working capital of ₹1,00,000 needed at the start of Year 1 is paid at the end of Year 0: outflow of ₹1,00,000 at Year 0.
  4. The increase of ₹40,000 needed at the start of Year 2 is paid at the end of Year 1: outflow of ₹40,000 at Year 1.
  5. Release at the end of Year 2: inflow of ₹1,40,000 at Year 2.
  6. Year 0 total = −₹90,000 − ₹1,00,000 = −₹1,90,000. PV = −₹1,90,000.
  7. Year 1 PV = −₹40,000 × 0.909 = −₹36,360.
  8. Year 2 PV = ₹1,40,000 × 0.826 = ₹1,15,640.
  9. Net PV of these items = −₹1,90,000 − ₹36,360 + ₹1,15,640 = −₹1,10,720.

Answer: The machine and working capital together have a present value of −₹1,10,720. This must be set against the operating cash flows of the project, which are not given here, so no overall NPV can be stated yet.

Exam tips

  • In objective questions, expect a list of figures with several irrelevant ones. Cross them out first, then calculate.
  • Look for words like already paid, committed, allocated, depreciation and interest. They usually signal an item to exclude.
  • In Section C, set out a clear cash flow table by year, with working capital and tax on separate lines. Marks are given for each correct line.
  • Where you exclude an item, say why in one short phrase. Examiners reward the reasoning.
  • Check the timing of working capital and tax. A one-year slip changes the discounting and costs marks.

Practice questions from Investment appraisal techniques

Relevant Cash Flows for Investment Appraisal in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Relevant Cash Flows for Investment Appraisal: frequently asked questions

What is the difference between a sunk cost and an opportunity cost?

A sunk cost has already been spent and cannot change, so it is ignored. An opportunity cost is a benefit you give up in the future by choosing the project, so it is included.

Why are financing costs ignored in investment appraisal?

The discount rate already reflects the return that finance providers require. If you also deduct interest from the cash flows, you count the cost of finance twice.

Is depreciation ever relevant in DCF?

Depreciation itself is not a cash flow, so it is ignored. The tax saving from capital allowances is relevant, because it reduces cash tax payments.

How do I treat working capital in an NPV question?

Calculate the change in working capital each year. An increase is an outflow and a decrease is an inflow. At the end of the project, the remaining working capital is normally released as an inflow.