Shrieves Casting Company
a. Define “incremental cash flow.” Incremental cash flows are the difference between the cash flows the firm will have if it implements the projects minus the cash flows it will have if it rejects the project. (426)
Incremental cash flows = Company’s cash flows - Company’s cash flows with the project without the project
(1.) Should you subtract interest expense or dividends when calculating project cash flow? No, you should not subtract interest expenses when finding a project’s cash flow. This is a mistake because the cost of debt is already embedded in the cost of capital, so subtracting interest payments from the project’s cash flows would amount to double counting interest costs. [426]
(2.) Suppose the firm had spent $100,000 last year to rehabilitate the production line site. Should this be included in the analysis? Explain. No, this is a sunk cost. This cost incurred in the past, is irreversible, and cannot be affected by the decision to accept or reject a project and therefore should be ignored. This cost cannot be recovered in the future regardless of whether or not a project is accepted. [427] (3.) Now assume that the plant space could be leased out to another firm at $25,000 per year. Should this be included in the analysis? If so, how? Yes, by accepting the project, the Shrieves Casting Company foregoes a possible annual cash flow of $25,000, which is an opportunity cost to be charged to the project. [427] The relevant cash flow is the annual after-tax opportunity cost as follows:
A-T opportunity cost = $25,000 (1 – T) = $25,000 (0.4) =
Incremental cash flows = Company’s cash flows - Company’s cash flows with the project without the project
(1.) Should you subtract interest expense or dividends when calculating project cash flow? No, you should not subtract interest expenses when finding a project’s cash flow. This is a mistake because the cost of debt is already embedded in the cost of capital, so subtracting interest payments from the project’s cash flows would amount to double counting interest costs. [426]
(2.) Suppose the firm had spent $100,000 last year to rehabilitate the production line site. Should this be included in the analysis? Explain. No, this is a sunk cost. This cost incurred in the past, is irreversible, and cannot be affected by the decision to accept or reject a project and therefore should be ignored. This cost cannot be recovered in the future regardless of whether or not a project is accepted. [427] (3.) Now assume that the plant space could be leased out to another firm at $25,000 per year. Should this be included in the analysis? If so, how? Yes, by accepting the project, the Shrieves Casting Company foregoes a possible annual cash flow of $25,000, which is an opportunity cost to be charged to the project. [427] The relevant cash flow is the annual after-tax opportunity cost as follows:
A-T opportunity cost = $25,000 (1 – T) = $25,000 (0.4) =