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
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
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.
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