Corporate Finance Core Principles and Applications Chapter 8

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CHAPTER 8 MAKING CAPITAL INVESTMENT DECISIONS Answers to Concept 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. a. Yes, the reduction in the sales of the company’s other products, referred to as erosion, should be treated as an incremental cash flow. These lost sales are included because they are a cost (a revenue reduction) that the firm must bear if it chooses to produce the new product. b. Yes, expenditures on plant and equipment should be treated as incremental cash flows. These are costs of the new product line.…show more content…
6. 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 would remain unchanged, financing costs are not relevant in the analysis of a project’s incremental cash flows according to the stand-alone principle. 7. 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. For example, if one project has a three-year life and the other has a five-year life, then a 15-year horizon is the minimum necessary to place the two projects on an equal footing, implying that one project will be repeated five times and the other will be repeated three times. Note the shortest common life may be quite long when there are more than two alternatives and/or the individual project lives are relatively long. Assuming this type of analysis is valid implies that the project cash flows remain the same over the common life, 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
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