Making Capital Investment Decisions

In this context, an opportunity cost refers to the value of an asset or other input that will be used in a project. The relevant cost is what the asset or input is actually worth today, not, for example, what it cost to acquire.

2. For tax purposes, a firm would choose MACRS because it provides for larger depreciation deductions earlier. These larger deductions reduce taxes, but have no other cash consequences. Notice that the choice between MACRS and straight-line is purely a time value issue; the total depreciation is the same, only the timing differs.

3. It’s probably only a mild over-simplification. Current liabilities will all be paid, presumably. The cash portion of current assets will be retrieved. Some receivables won’t be collected, and some inventory will not be sold, of course. Counterbalancing these losses is the fact that inventory sold above cost (and not replaced at the end of the project’s life) acts to increase working capital. These effects tend to offset one another.

4. Management’s discretion to set the firm’s capital structure is applicable at the firm level. Since any one particular project could be financed entirely with equity, another project could be financed with debt, and the firm’s overall capital structure remains unchanged, financing costs are not relevant in the analysis of a project’s incremental cash flows according to the stand-alone principle.

5. The EAC approach is appropriate when comparing mutually exclusive projects with different lives that will be replaced when they wear out. This type of analysis is necessary so that the projects have a common life span over which they can be compared; in effect, each project is assumed to exist over an infinite horizon of N-year repeating projects. Assuming that this type of analysis is valid implies that the project cash flows remain the same forever, thus ignoring the possible effects of, among other things: (1) inflation, (2) changing economic conditions, (3) the increasing unreliability of cash flow estimates that occur far into the future, and (4) the possible effects of future technology improvement that could alter the project cash flows.

6. Depreciation is a non-cash expense, but it is tax-deductible on the income statement. Thus depreciation causes taxes paid, an actual cash outflow, to be reduced by an amount equal to the depreciation tax shield tcD. A reduction in taxes that would otherwise be paid is the same thing as a cash inflow, so the effects of the depreciation tax shield must be added in to get the total incremental aftertax cash flows.

7. There are two particularly important considerations. The first is erosion. Will the essentialized book simply displace copies of the existing book that would have otherwise been sold? This is of special concern given the lower price. The second consideration is competition. Will other publishers step in and produce such a product? If so, then any erosion is much less relevant. A particular concern to book publishers (and producers of a variety of other product types) is that the publisher only makes money from the sale of new books. Thus, it is important to examine whether the new book would displace sales of used books (good from the publisher’s perspective) or new books (not good). The concern arises any time there is an active market for used product.

8. Definitely. The damage to Porsche’s reputation is definitely a factor the company needed to consider. If the reputation was damaged, the company would have lost sales of its existing car lines.

9. One company may be able to produce at lower incremental cost or market better. Also, of course, one of the two may have made a mistake!

10. Porsche would recognize that the outsized profits would dwindle as more product comes to market and competition becomes more intense.

Solutions to Questions and Problems

NOTE: All end of chapter problems were solved using a spreadsheet. Many problems require multiple steps. Due to space and readability constraints, when these intermediate steps are included in this solutions manual, rounding may appear to have occurred. However, the final answer for each problem is found without rounding during any step in the problem.

Basic

1. The ZAR 5 million acquisition cost of the land six years ago is a sunk cost. The ZAR 5.4 million current aftertax value of the land is an opportunity cost if the land is used rather than sold off. The ZAR 10.4 million cash outlay and ZAR 850,000 grading expenses are the initial fixed asset investments needed to get the project going. Therefore, the proper year zero cash flow to use in evaluating this project is

ZAR 5,400,000 + 10,400,000 + 850,000 = ZAR 16,650,000

2. Sales due solely to the new product line are:

20,000($12,000) = $240,000,000

Increased sales of the motor home line occur because of the new product line introduction; thus:

5,000($45,000) = $225,000,000

in new sales is relevant. Erosion of luxury motor coach sales is also due to the new mid-size campers; thus:

1,300($95,000) = $123,500,000 loss in sales

is relevant. The net sales figure to use in evaluating the new line is thus:

$240,000,000 + 225,000,000 вЂ" 123,500,000 = $341,500,000

3. We need to construct a basic income statement. The income statement is:

Sales KRW 89,500,000

Variable costs 53,700,000

Fixed costs 14,600,000

Depreciation 622,000

EBT KRW 20,578,000

Taxes@35% 7,202,300

Net income KRW 13,375,700

4. To find the OCF, we need to complete the income statement as follows:

Sales $ 912,400

Costs 593,600

Depreciation 135,000

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