Corporate Finance Core Principles and Applications Chapter 8

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CHAPTER 8
MAKING CAPITAL INVESTMENT DECISIONS

Answers to Concept Questions

1.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.a.Yes, the reduction in the sales of the company’s other products, referred to as erosion, should be treated as an incremental cash flow. These lost sales are included because they are a cost (a revenue reduction) that the firm must bear if it chooses to produce the new product.

b.Yes, expenditures on plant and equipment should be treated as incremental cash flows. These are costs of the new product line. However, if these expenditures have already occurred (and cannot be recaptured through a sale of the plant and equipment), they are sunk costs and are not included as incremental cash flows.

c.No, the research and development costs should not be treated as incremental cash flows. The costs of research and development undertaken on the product during the past three years are sunk costs and should not be included in the evaluation of the project. Decisions made and costs incurred in the past cannot be changed. They should not affect the decision to accept or reject the project.

d.Yes, the annual depreciation expense must be taken into account when calculating the cash flows related to a given project. While depreciation is not a cash expense that directly affects cash flow, it decreases a firm’s net income and hence, lowers its tax bill for the year. Because of this depreciation tax shield, the firm has more cash on hand at the end of the year than it would have had without expensing depreciation.

e. No, dividend payments should not be treated as incremental cash flows. A firm’s decision to pay or not pay dividends is independent of the decision to accept or reject any given investment project. For this reason, dividends are not an incremental cash flow to a given project. Dividend policy is discussed in more detail in later chapters.

f. Yes, the resale value of plant and equipment at the end of a project’s life should be treated as an incremental cash flow. The price at which the firm sells the equipment is a cash inflow, and any difference between the book value of the equipment and its sale price will create accounting gains or losses that result in either a tax credit or liability.

g.Yes, salary and medical costs for production employees hired for a project should be treated as incremental cash flows. The salaries of all personnel connected to the project must be included as costs of that project.

3. Item I is a relevant cost because the opportunity to sell the land is lost if the new golf club is produced. Item II is also relevant because the firm must take into account the erosion of sales of existing products when a new product is introduced. If the firm produces the new club, the earnings from the existing clubs will decrease, effectively creating a cost that must be included in the decision. Item III is not relevant because the costs of research and development are sunk costs. Decisions made in the past cannot be changed. They are not relevant to the production of the new clubs.

4.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.

5.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...
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