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.
Solutions to Questions and Problems
The ZAR 5 million acquisition cost of the land six years ago is a sunk cost. The ZAR 5.4 million
current aftertax value of the land is an opportunity cost if the land is used rather than sold off. The
ZAR 10.4 million cash outlay and ZAR 850,000 grading expenses are the initial fixed asset
investments needed to get the project going. Therefore, the proper year zero cash flow to use in