FINA 395 Chapter Notes - Chapter 8: Working Capital, Sunk Costs, Real Interest Rate

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25 Jan 2015

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Chapter 8: net present value and capital budgeting: yes, the reduction in the sales of the company"s other products, referred to as erosion, and should be treated as an incremental cash flow. These are costs of the new product line. However, if these expenditures have already occurred, they are sunk costs and are not included as incremental cash flows: 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 3 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: yes, the annual cca expense should be treated as an incremental cash flow. Cca expense must be taken into account when calculating the cash flows related to a given project.

Related Questions

2. Incremental Cash Flows: Which of the following should be treated as an incremental cash flow when computing the NPV of an investment?

A. A reduction in the sales of a companyâs other products caused by the investment.

B. An expenditure on plant and equipment that has not yet been made and will be made only if the project is accepted.

C. Costs of research and development undertaken in connection with the product during the past three years.

D. Annual depreciation expense from the investment

E. Dividend payments by the firm

F. The resale value of plant and equipment the end of the projectâs life.

G. Salary and medical costs for production personnel who will be employed only if the project is accepted.

Problem 12-9
New project analysis

You must evaluate a proposal to buy a new milling machine. The base price is $164,000, and shipping and installation costs would add another $7,000. The machine falls into the MACRS 3-year class, and it would be sold after 3 years for $82,000. The applicable depreciation rates are 33%, 45%, 15%, and 7%. The machine would require a $7,500 increase in net operating working capital (increased inventory less increased accounts payable). There would be no effect on revenues, but pretax labor costs would decline by $41,000 per year. The marginal tax rate is 35%, and the WACC is 11%. Also, the firm spent $5,000 last year investigating the feasibility of using the machine.

How should the $5,000 spent last year be handled?

The cost of research is an incremental cash flow and should be included in the analysis.

Only the tax effect of the research expenses should be included in the analysis.

Last year's expenditure should be treated as a terminal cash flow and dealt with at the end of the project's life. Hence, it should not be included in the initial investment outlay.

Last year's expenditure is considered an opportunity cost and does not represent an incremental cash flow. Hence, it should not be included in the analysis.

Last year's expenditure is considered a sunk cost and does not represent an incremental cash flow. Hence, it should not be included in the analysis.

-Select-IIIIIIIVVItem 1

What is the initial investment outlay for the machine for capital budgeting purposes, that is, what is the Year 0 project cash flow? Round your answer to the nearest cent.
$

What are the project's annual cash flows during Years 1, 2, and 3? Round your answer to the nearest cent.
Year 1 $
Year 2 $
Year 3 $

Should the machine be purchased?
-Select-yesno

You must evaluate a proposal to buy a new milling machine. The base price is $167,000, and shipping and installation costs would add another $9,000. The machine falls into the MACRS 3-year class, and it would be sold after 3 years for $108,550. The applicable depreciation rates are 33%, 45%, 15%, and 7%. The machine would require a $6,500 increase in net operating working capital (increased inventory less increased accounts payable). There would be no effect on revenues, but pretax labor costs would decline by $38,000 per year. The marginal tax rate is 35%, and the WACC is 10%. Also, the firm spent $5,000 last year investigating the feasibility of using the machine.

How should the $5,000 spent last year be handled?

I. The cost of research is an incremental cash flow and should be included in the analysis.

II. Only the tax effect of the research expenses should be included in the analysis.

III. Last year's expenditure should be treated as a terminal cash flow and dealt with at the end of the project's life. Hence, it should not be included in the initial investment outlay.

IV. Last year's expenditure is considered an opportunity cost and does not represent an incremental cash flow. Hence, it should not be included in the analysis.

V. Last year's expenditure is considered a sunk cost and does not represent an incremental cash flow. Hence, it should not be included in the analysis.

I, II, III, IV or V?

What is the initial investment outlay for the machine for capital budgeting purposes, that is, what is the Year 0 project cash flow? Round your answer to the nearest cent.
$

What are the project's annual cash flows during Years 1, 2, and 3? Round your answer to the nearest cent.
Year 1 $
Year 2 $
Year 3 $

Should the machine be purchased?

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FINA 395 Chapter Notes - Chapter 8: Working Capital, Sunk Costs, Real Interest Rate

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