# Capital budgeting analysis should only include those

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Capital budgeting analysis should only include those cash flows which will be affected bythe decision.Sunk costs are unrecoverable and cannot be changed, so they have nobearing on the capital budgeting decision. Opportunity costs represent the cash flows thefirm gives up by investing in this project rather than its next best alternative, andexternalities are the cash flows (both positive and negative) to other projects that resultfrom the firm taking on this project.These cash flows occur only because the firm tookon the capital budgeting project; therefore, they must be included in the analysis.11-5When a firm takes on a new capital budgeting project, it typically must increase itsinvestment in receivables and inventories, over and above the increase in payables andaccruals, thus increasing its net operating working capital.Since this increase must befinanced, it is included as an outflow in Year 0 of the analysis.At the end of the project’slife, inventories are depleted and receivables are collected.Thus, there is a decrease inNOWC, which is treated as an inflow.11-7The costs associated with financing are reflected in the weighted average cost of capital.To include interest expense in the capital budgeting analysis would “double count” thecost of debt financing.13
SOLUTIONS TO END-OF-CHAPTER PROBLEMS11-4Cash outflow = \$40,000.Increase in annual after-tax cash flows:CF = \$9,000.Place the cash flows on a time line:01210|||• • •|-110,00019,00019,00019,000With a financial calculator, input the appropriate cash flows into the cash flow register,input I/YR = 10, and then solve for NPV = \$6,746.78.Thus, Chen should purchase thenew machine.11-5a.The MACRS rates are 33.33%, 44.45%, 14.81%, and 7.41%. The first MACRSdepreciation expense is 33.33%(\$1,700,000) = \$566,610. The others are calculatedsimilarly. The applicable depreciation values are as follows for the two scenarios:Scenario 1Scenario 2Year(Straight Line)(MACRS)1\$425,000\$566,6102425,000755,6503425,000251,7704425,000125,970b.To find the difference in net present values under these two methods, we mustdetermine the difference in incremental cash flows each method provides.Thedepreciation expenses cannot simply be subtracted from each other, as there are taxramifications due to depreciation expense. The full depreciation expense is subtractedfrom Revenues to get operating income, and then taxes due are computedThen,1410
depreciation is added to after-tax operating income to obtain the project’s operatingcash flow.Therefore, if the tax rate is 40%, only 60% of the depreciation expense isactually subtracted out during the after-tax operating income calculation and the fulldepreciation expense is added back to calculate operating income.So, there is a taxbenefit associated with the depreciation expense that amounts to 40% of thedepreciation expense.Therefore, the differences between depreciation expensesunder each scenario should be computed and multiplied by 0.4 to determine thebenefit provided by the depreciation expense.

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