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Ryerson University
FIN 300
Scott Anderson

CHAPTER 10 Making Capital Investment Decisions Answers to Concepts Review and Critical Thinking Questions 1. An opportunity cost is the most valuable alternative that is foregone if a particular project is undertaken. The relevant opportunity cost is what the asset or input is actually worth today, not, for example, what it cost to acquire. 2. Its probably only a mild over-simplification. Current liabilities will all be paid presumably. The cash portion of current assets will be retrieved. Some receivables wont 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 projects life) acts to increase working capital. These effects tend to offset. 3. 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. 4. 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 t Dc 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 included to get the total incremental aftertax cash flows. 5. 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 publishers perspective) or new books (not good). The concern arises any time there is an active market for used product. 6. This market was heating up rapidly, and a number of other competitors were planning on entering. Any erosion of existing services would be offset by an overall increase in market demand. 7. Air Canada should have realized that abnormally large profits would dwindle as more supply of services came into the market and competition became 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 97 1. The $5 million acquisition cost of the land six years ago is a sunk cost. The $5.4 million current aftertax value of the land is an opportunity cost if the land is used rather than sold off. The $10.4 million cash outlay and $650,000 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 $5,400,000 + 10,400,000 + 650,000 = $16,450,000 2. Sales due solely to the new product line are: 21,000($12,000) = $252,000,000 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($85,000) = $110,500,000 loss in sales is relevant. The net sales figure to use in evaluating the new line is thus: $252,000,000 + 225,000,000 110,500,000 = $366,500,000 3. We need to construct a basic income statement. The income statement is: Sales $ 650,000 Variable costs 390,000 Fixed costs 158,000 Depreciation 75,000 EBT $ 27,000 [email protected]% 9,450 Net income $ 17,550 4. To find the OCF, we need to complete the income statement as follows: Sales $ 912,400 Costs 593,600 Depreciation 135,000 EBT $ 183,800 [email protected]% 62,492 Net income $ 121,308 The OCF for the company is: OCF = EBIT + Depreciation Taxes OCF = $183,800 + 135,000 62,492 OCF = $256,308 The depreciation tax shield is the depreciation times the tax rate, so: Depreciation tax shield =ct Depreciation Depreciation tax shield = .34($135,000) 98 Depreciation tax shield = $45,900 The depreciation tax shield shows us the increase in OCF by being able to expense depreciation. 5. To calculate the OCF, we first need to calculate net income. The income statement is: Sales $ 85,000 Variable costs 43,000 Depreciation 3,000 EBT $ 39,000 [email protected]% 15,600 Net income $ 23,400 Using the most common financial calculation for OCF, we get: OCF = EBIT + Depreciation Taxes = $39,000 + 3,000 15,600 OCF = $26,400 The top-down approach to calculating OCF yields: OCF = Sales Costs Taxes = $85,000 43,000 15,600 OCF = $26,400 The tax-shield approach is: OCF = (Sales Costs)(1 C ) C t Depreciation OCF = ($85,000 43,000)(1 .40) + .40(3,000) OCF = $26,400 And the bottom-up approach is: OCF = Net income + Depreciation = $23,400 + 3,000 OCF = $26,400 All four methods of calculating OCF should always give the same answer. 6. Sales $ 900,000 Variable costs 468,000 Fixed costs 190,000 CCA 112,000 EBIT $ 130,000 [email protected]% 50,700 Net income $ 79,300 7. Cash flow year 0 = -850,000 Cash flow years 1 through 5 = 490,000(1 .40) = $294,000 PV of CCATS = 850,000(.3)(.4) x (1 + .5(.12)) .12 + .3 1 + .12 = $229,846.94 NPV = -850,000 + 294,000 x PVIFA (12%, 5) + 229,846.94 = $439,651.14 99 8. Cash flow year 0 = -850,000 - 37,500 = -$887,500 Cash flow years 1 through 5 = 455,000(1 .4) = $294,000 Ending cash flow = 100,000 + 37,500 = $137,500 100
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