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CHAPTER8MAKINGCAPITALINVESTMENTDECISIONSAnswerstoConceptsReviewandCriticalThinkingQuestions1.Inthiscontext,anopportunitycostreferstothevalueofanassetorotherinputthatwillbeusedinaproject.Therelevantcostiswhattheassetorinputisactuallyworthtoday,not,forexample,whatitcosttoacquire.2.a.Yes,thereductioninthesalesofthecompany’sotherproducts,referredtoaserosion,andshouldbetreatedasanincrementalcashflow.Theselostsalesareincludedbecausetheyareacost(arevenuereduction)thatthefirmmustbearifitchoosestoproducethenewproduct.b.Yes,expendituresonplantandequipmentshouldbetreatedasincrementalcashflows.Thesearecostsofthenewproductline.However,iftheseexpenditureshavealreadyoccurred,theyaresunkcostsandarenotincludedasincrementalcashflows.c.No,theresearchanddevelopmentcostsshouldnotbetreatedasincrementalcashflows.Thecostsofresearchanddevelopmentundertakenontheproductduringthepast3yearsaresunkcostsandshouldnotbeincludedintheevaluationoftheproject.Decisionsmadeandcostsincurredinthepastcannotbechanged.Theyshouldnotaffectthedecisiontoacceptorrejecttheproject.d.Yes,theannualdepreciationexpenseshouldbetreatedasanincrementalcashflow.Depreciationexpensemustbetakenintoaccountwhencalculatingthecashflowsrelatedtoagivenproject.Whiledepreciationisnotacashexpensethatdirectlyaffectscashflow,itdecreasesafirm’snetincomeandhence,lowersitstaxbillfortheyear.Becauseofthisdepreciationtaxshield,thefirmhasmorecashonhandattheendoftheyearthanitwouldhavehadwithoutexpensingdepreciation.e.No,dividendpaymentsshouldnotbetreatedasincrementalcashflows.Afirm’sdecisiontopayornotpaydividendsisindependentofthedecisiontoacceptorrejectanygiveninvestmentproject.Forthisreason,itisnotanincrementalcashflowtoagivenproject.Dividendpolicyisdiscussedinmoredetailinlaterchapters.f.Yes,theresalevalueofplantandequipmentattheendofaproject’slifeshouldbetreatedasanincrementalcashflow.Thepriceatwhichthefirmsellstheequipmentisacashinflow,andanydifferencebetweenthebookvalueoftheequipmentanditssalepricewillcreategainsorlossesthatresultineitherataxcreditorliability.g.Yes,salaryandmedicalcostsforproductionemployeeshiredforaprojectshouldbetreatedasincrementalcashflows.Thesalariesofallpersonnelconnectedtotheprojectmustbeincludedascostsofthatproject.3.ItemIisarelevantcostbecausetheopportunitytosellthelandislostifthenewgolfclubisproduced.ItemIIisalsorelevantbecausethefirmmusttakeintoaccounttheerosionofsalesofexistingproductswhenanewproductisintroduced.Ifthefirmproducesthenewclub,theearningsfromtheexistingclubswilldecrease,effectivelycreatingacostthatmustbeincludedinthedecision.ItemIIIisnotrelevantbecausethecostsofResearchandDevelopmentaresunkcosts.Decisionsmadeinthepastcannotbechanged.Theyarenotrelevanttotheproductionofthenewclubs.4.Fortaxpurposes,afirmwouldchooseMACRSbecauseitprovidesforlargerdepreciationdeductionsearlier.Theselargerdeductionsreducetaxes,buthavenoothercashconsequences.NoticethatthechoicebetweenMACRSandstraight-lineispurelyatimevalueissue;thetotaldepreciationisthesame;onlythetimingdiffers.5.It’sprobablyonlyamildover-simplification.Currentliabilitieswillallbepaid,presumably.Thecashportionofcurrentassetswillberetrieved.Somereceivableswon’tbecollected,andsomeinventorywillnotbesold,ofcourse.Counterbalancingtheselossesisthefactthatinventorysoldabovecost(andnotreplacedattheendoftheproject’slife)actstoincreaseworkingcapital.Theseeffectstendtooffsetoneanother.6.Management’sdiscretiontosetthefirm’scapitalstructureisapplicableatthefirmlevel.Sinceanyoneparticularprojectcouldbefinancedentirelywithequity,anotherprojectcouldbefinancedwithdebt,andthefirm’soverallcapitalstructureremainsunchanged,financingcostsarenotrelevantintheanalysisofaproject’sincrementalcashflowsaccordingtothestand-aloneprinciple.7.TheEACapproachisappropriatewhencomparingmutuallyexclusiveprojectswithdifferentlivesthatwillbereplacedwhentheywearout.Thistypeofanalysisisnecessarysothattheprojectshaveacommonlifespanoverwhichtheycanbecompared;ineffect,eachprojectisassumedtoexistoveraninfinitehorizonofN-yearrepeatingprojects.Assumingthatthistypeofanalysisisvalidimpliesthattheprojectcashflowsremainthesameforever,thusignoringthepossibleeffectsof,amongotherthings:(1)inflation,(2)changingeconomicconditions,(3)theincreasingunreliabilityofcashflowestimatesthatoccurfarintothefuture,and(4)thepossibleeffectsoffuturetechnologyimprovementthatcouldaltertheprojectcashflows.8.Depreciationisanon-cashexpense,butitistax-deductibleontheincomestatement.Thusdepreciationcausestaxespaid,anactualcashoutflow,tobereducedbyanamountequaltothedepreciationtaxshield,tcD.Areductionintaxesthatwouldotherwisebepaidisthesamethingasacashinflow,sotheeffectsofthedepreciationtaxshieldmustbeaddedintogetthetotalincrementalaftertaxcashflows.9.Therearetwoparticularlyimportantconsiderations.Thefirstiserosion.Willthe“essentialized”booksimplydisplacecopiesoftheexistingbookthatwouldhaveotherwisebeensold?Thisisofspecialconcerngiventhelowerprice.Thesecondconsiderationiscompetition.Willotherpublishersstepinandproducesuchaproduct?Ifso,thenanyerosionismuchlessrelevant.Aparticula