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CHAPTER 10 MAKING CAPITAL INVESTMENT DECISIONS Answers to Concepts Review and Critical Thinking Questions 1. 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. 2. 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. 6. 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 c 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. 7. 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 publisher’s perspective) or new books (not good). The concern arises any time there is an active market for used product. Solutions to Questions and Problems 1. The $6 million acquisition cost of the land six years ago is a sunk cost. The $6.4 million current aftertax value of the land is an opportunity cost if the land is used rather than sold off. The $14.2 million cash outlay and $890,000 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 $6,400,000 + 14,200,000 + 890,000 = $21,490,000 2. Sales due solely to the new product line are: 19,000($13,000) = $247,000,000 Increased sales of the motor home line occur because of the new product line introduction; thus: 4,500($53,000) = $238,500,000
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in new sales is relevant. Erosion of luxury motor coach sales is also due to the new mid-size campers; thus: 900($91,000) = $81,900,000 loss in sales
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