MAKING CAPITAL INVESTMENT
Answers to Concepts Review and Critical Thinking Questions
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.
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.
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.
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 remains unchanged, financing costs are not relevant in
the analysis of a project’s incremental cash flows according to the stand-alone principle.
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.
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
D. 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.