Homework Chapter 10
Homework Chapter 10
An opportunity cost in this context refers to the cost of an asset or other input that has been
allocated for a project. The asset's or input's present value—rather than, say, the asset's original
acquisition cost—is the relevant cost.
2. Given the choice, would a firm prefer to use MACRS depreciation or straight-line depreciation?
Why?
A business may use MACRS for tax reasons since it permits larger depreciation deductions in
the first several years. With no additional financial consequences, these higher deductions
result in lower taxes. It is crucial to remember that choosing between MACRS and straight-line
depreciation is only based on time value; the total amount of depreciation does not change; only
the timing does.
3. In our capital budgeting examples, we assumed that a firm would recover all of the working
capital it invested in a project. Is this a reasonable assumption? When might it not be valid?
It's oversimplifying, but only a little. It is anticipated that the cash portion of current assets will
be retrieved and that all current liabilities would be paid off. It is possible that some
merchandise may remain unsold and that not all receivables will be recovered. On the other
hand, selling inventory for more than it costs—especially if it isn't restocked before a project's
conclusion helps to increase working capital. In general, these disparate impacts cancel one
other out.
4. Suppose a financial manager is quoted as saying, “Our firm uses the stand-alone principle.
Because we treat projects like minifirms in our evaluation process, we include financing costs
because they are relevant at the firm level.” Critically evaluate this statement.
At the organizational level, management's latitude in choosing the company's capital structure is
significant. This implies that while the firm's basic capital structure stays the same, specific initiatives
inside the company may be funded in a variety of ways utilizing a combination of debt and equity.
Financing expenses are disregarded when examining a project's incremental cash flows using the
stand-alone approach. This suggests that the evaluation of a project's incremental cash flows is
unaffected by the particular financing strategy used for it.
5. When is EAC analysis appropriate for comparing two or more projects? Why is this method
used? Are there any implicit assumptions required by this method that you find troubling?
Explain
Comparing projects that are mutually exclusive and have distinct lifespans that will be replaced as
they wear out, the EAC method makes sense. This kind of study is required so that the projects may
be compared across a common life span; essentially, it is assumed that each project will exist over an
infinite horizon of N consecutive years. If this kind of analysis is valid, then the project cash flows are
assumed to be constant throughout time, thereby ignoring potential effects such as inflation, shifting
economic conditions, growing unreliability of cash flow estimates for far-off events, and potential
effects of future technological advancements that could change the project cash flows.
6. “When evaluating projects, we’re concerned with only the relevant incremental aftertax cash
flows. Therefore, because depreciation is a noncash expense, we should ignore its effects when
evaluating projects.” Critically evaluate this statement
While depreciation itself is a non-cash expense, the income statement accounts for it in tax
deductions. Consequently, depreciation lowers the taxes paid considered a real cash outflowby the
depreciation tax shield. To calculate the total additional after-tax cash flows accurately, the effects
of the depreciation tax shield must be considered. The reduction in taxes, which would have been
paid otherwise, is treated as a cash inflow in this context.
7. A major college textbook publisher has an existing finance textbook. The publisher is debating
whether to produce an “essentialized” version, meaning a shorter (and lower-priced) book.
What are some of the considerations that should come into play? To answer the next three
questions, refer to the following example. In 2003, Porsche unveiled its new sports utility
vehicle (SUV), the Cayenne. With a price tag of over $40,000, the Cayenne went from zero to
62 mph in 9.7 seconds. Porsche’s decision to enter the SUV market was a response to the
runaway success of other high-priced SUVs such as the Mercedes-Benz M-class. Vehicles in
this class had generated years of high profits. The Cayenne certainly spiced up the market, and
Porsche subsequently introduced the Cayenne Turbo S, which goes from zero to 60 mph in 3.8
seconds and has a (limited!) top speed of 183 mph. The price tag for the Cayenne Turbo S in
2020? About $163,250! Some analysts questioned Porsche’s entry into the luxury SUV market.
The analysts were concerned not only that Porsche was a late entry into the market, but also
that the introduction of the Cayenne would damage Porsche’s reputation as a maker of
highperformance automobiles.
There are two crucial aspects to consider. The first is erosion: will the "essentialized" book
replace the copies that the existing book would have sold. This is a significant concern. The
second factor is competition: could other publishers step in and produce a similar product. In
such a scenario, erosion becomes less critical. The fact that book publishers only generate
revenue from the sale of new books is a specific source of worry for them, as well as for
manufacturers of various other products. It is vital to determine whether the new book would
substitute sales of new or used books preferable from the publisher's perspective. Whenever
there is a market for the old product, there is cause for concern.
8. In evaluating the Cayenne, would you use the term erosion to describe the possible damage to
Porsche’s reputation?
Yes we can see that the damage to Porsche's brand was unquestionably a concern that the
company had to consider. If the reputation had been marred, the corporation would likely have
experienced a decline in sales for its existing car models.
9. Porsche was one of the last manufacturers to enter the sports utility vehicle market. Why
would one company decide to proceed with a product when other companies, at least initially,
decide not to enter the market?
One company might excel in marketing the car or produce it with a lower incremental cost.
Naturally, there is also the possibility that one of the two companies made an error.
1.Parker & Stone, Inc., is looking at setting up a new manufacturing plant in South Park to produce
garden tools. The company bought some land six years ago for $2.8 million in anticipation of using it as
a warehouse and distribution site, but the company has since decided to rent these facilities from a
competitor instead. If the land were sold today, the company would net $3.2 million. The company
wants to build its new manufacturing plant on this land; the plant will cost $14.3 million to build, and
the site requires $825,000 worth of grading before it is suitable for construction. What is the proper
cash flow amount to use as the initial investment in fixed assets when evaluating this project? Why?
Sales 515,000
Variable costs 185,400
Fixed costs 173,000
Depreciation __46,000
EBT $ 110,600
Taxes (21%) _ 23,226
Net income $ 87,374
4. Fill in the missing numbers and then calculate the OCF. What is the depreciation tax shield?
Sales 704,600
Costs 527,300
Depreciation 82,100
EBT $95,200
Taxes (22%) 20,944
Net income 74,256
OCF = $95,200 + 82,100 – 20,944 = $156,356
Depreciation tax shield = .22($82,100) = $18,062
5. A proposed new project has projected sales of $215,000, costs of $104,000, and depreciation of
$25,300. The tax rate is 23 percent. Calculate operating cash flow using the four different approaches
described in the chapter and verify that the answer is the same in each case.
Sales 215,000
Costs 104,000
Depreciation 25,300
EBT $ 85,700
Taxes (23%) 19,711
Net income $ 65,989
(normal) OCF = $85,700 + 25,300 – 19,711= $91,289
(top-down) OCF = $215,000 – 104,000 – 19,711 = $91,289
(tax shield) OCF = ($215,000 – 104,000)(1 – .23) + .23($25,300) = $91,289
(bottom-up) OCF = $65,989 + 25,300 = $91,289
9. Esfandairi Enterprises is considering a new threeyear expansion project that requires an initial fixed
asset investment of $2.18 million. The fixed asset will be depreciated straight-line to zero over its
three-year tax life, after which time it will be worthless. The project is estimated to generate $1.645
million in annual sales, with costs of $610,000. If the tax rate is 21 percent, what is the OCF for this
project?