Chapter 06 - Making Capital Investment Decisions

CHAPTER 6

MAKING CAPITAL INVESTMENT DECISIONS

Answers to Concepts Review and Critical Thinking 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.

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Chapter 06 - Making Capital Investment Decisions

3. Item (a) is a relevant cost because the opportunity to sell the land is lost if the new golf club is

produced. Item (b) 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 (c) 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 club.

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 (and not replaced at the end of the project’s life) acts to increase working capital. These effects tend to offset one another.

6. 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 would remain unchanged. Financing costs are not relevant in the analysis of a project’s incremental cash flows according to the stand-alone principle.

7. 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. For example, if one project has a three-year life and the other has a five-year life, then a 15-year horizon is the minimum necessary to place the two projects on an equal footing, implying that one project will be repeated five times and the other will be repeated three times. Note the shortest common life may be quite long when there are more than two alternatives and/or the individual project lives are relatively long. Assuming this type of analysis is valid implies that the project cash flows remain the same over the common life, 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.

8. 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.

9. 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.

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Chapter 06 - Making Capital Investment Decisions

10. Definitely. The damage to Porsche’s reputation is a factor the company needed to consider. If the

reputation was damaged, the company would have lost sales of its existing car lines.

11. 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!

12. Porsche would recognize that the outsized profits would dwindle as more products come 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. Using the tax shield approach to calculating OCF, we get:

OCF = (Sales – Costs)(1 – tC) + tCDepreciation OCF = [($4.75 × 1,500) – ($2.30 × 1,500)](1 – 0.34) + 0.34($9,000/5) OCF = $3,037.50 So, the NPV of the project is: NPV = –$9,000 + $3,037.50(PVIFA14%,5) NPV = $1,427.98

2. We will use the bottom-up approach to calculate the operating cash flow for each year. We also must

be sure to include the net working capital cash flows each year. So, the net income and total cash flow each year will be: Year 1 Year 2 Year 3 Year 4 Sales $12,500 $13,000 $13,500 $10,500 Costs 2,700 2,800 2,900 2,100 Depreciation 6,000 6,000 6,000 6,000 EBT $3,800 $4,200 $4,600 $2,400 Tax 1,292 1,428 1,564 816 Net income $2,508 $2,772 $3,036 $1,584 OCF 0 $8,508 $8,772 $9,036 $7,584 Capital spending –$24,000 0 0 0 0 NWC –300 –350 –400 –300 1,350 Incremental cash flow –$24,300 $8,158 $8,372 $8,736 $8,934

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Chapter 06 - Making Capital Investment Decisions

3. 4.

The NPV for the project is:

NPV = –$24,300 + $8,158 / 1.12 + $8,372 / 1.122 + $8,736 / 1.123 + $8,934 / 1.124 NPV = $1,553.87

Using the tax shield approach to calculating OCF, we get: OCF = (Sales – Costs)(1 – tC) + tCDepreciation

OCF = ($1,120,000 – 480,000)(1 – 0.35) + 0.35($1,400,000/3) OCF = $579,333.33

So, the NPV of the project is:

NPV = –$1,400,000 + $579,333.33(PVIFA12%,3) NPV = –$8,539.09

The cash outflow at the beginning of the project will increase because of the spending on NWC. At the end of the project, the company will recover the NWC, so it will be a cash inflow. The sale of the equipment will result in a cash inflow, but we also must account for the taxes which will be paid on this sale. So, the cash flows for each year of the project will be:

Year Cash Flow

0 – $1,685,000 = –$1,400,000 – 285,000 1 579,333.33 2 579,333.33 3 1,010,583.33 = $579,333.33 + 285,000 + 225,000 + (0 – 225,000)(.35) And the NPV of the project is: NPV = –$1,685,000 + $579,333.33(PVIFA12%,2) + ($1,010,583.33 / 1.123) NPV = $13,416.15

5. First we will calculate the annual depreciation for the equipment necessary for the project. The

depreciation amount each year will be: Year 1 depreciation = $1,400,000(0.3333) = $466,620 Year 2 depreciation = $1,400,000(0.4445) = $622,300 Year 3 depreciation = $1,400,000(0.1481) = $207,340 So, the book value of the equipment at the end of three years, which will be the initial investment

minus the accumulated depreciation, is: Book value in 3 years = $1,400,000 – ($466,620 + 622,300 + 207,340) Book value in 3 years = $103,740 The asset is sold at a gain to book value, so this gain is taxable. Aftertax salvage value = $225,000 + ($103,740 – 225,000)(0.35) Aftertax salvage value = $182,559

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Chapter 06 - Making Capital Investment Decisions

6.

To calculate the OCF, we will use the tax shield approach, so the cash flow each year is: OCF = (Sales – Costs)(1 – tC) + tCDepreciation

Year 0 1 2 3

Cash Flow – $1,685,000

579,317 633,805 956,128

= –$1,400,000 – 285,000

= ($640,000)(.65) + 0.35($466,620) = ($640,000)(.65) + 0.35($622,300)

= ($640,000)(.65) + 0.35($207,340) + $182,559 + 285,000

Remember to include the NWC cost in Year 0, and the recovery of the NWC at the end of the project. The NPV of the project with these assumptions is:

NPV = – $1,685,000 + $579,317/1.12 + $633,805/1.122 + $956,128/1.123 NPV = $18,065.81

First, we will calculate the annual depreciation of the new equipment. It will be: Annual depreciation charge = $670,000/5 Annual depreciation charge = $134,000 The aftertax salvage value of the equipment is: Aftertax salvage value = $50,000(1 – 0.35) Aftertax salvage value = $32,500 Using the tax shield approach, the OCF is: OCF = $240,000(1 – 0.35) + 0.35($134,000) OCF = $202,900

Now we can find the project IRR. There is an unusual feature that is a part of this project. Accepting this project means that we will reduce NWC. This reduction in NWC is a cash inflow at Year 0. This reduction in NWC implies that when the project ends, we will have to increase NWC. So, at the end of the project, we will have a cash outflow to restore the NWC to its level before the project. We also must include the aftertax salvage value at the end of the project. The IRR of the project is: NPV = 0 = –$670,000 + 85,000 + $202,900(PVIFAIRR%,5) + [($202,900 + 32,500 – 85,000) / (1+IRR)5] IRR = 20.06%

7.

First, we will calculate the annual depreciation of the new equipment. It will be: Annual depreciation = $375,000/5 Annual depreciation = $75,000

Now, we calculate the aftertax salvage value. The aftertax salvage value is the market price minus (or plus) the taxes on the sale of the equipment, so: Aftertax salvage value = MV + (BV – MV)tc

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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.