Learning Module 5 - Chapter 6

Erosion​In evaluating the Cayenne, would you consider the possible damage to Porsche's reputation as erosion?

Definitely. The damage to Porsche's reputation is a factor the company needed to consider. If the reputation were to be damaged, the company would have lost sales of its existing car lines.

Cash Flow and Depreciation ​"When evaluating projects, we're only concerned with the relevant incremental aftertax cash flows. Therefore, because depreciation is a noncash expense, we should ignore its effects when evaluating projects." Critically evaluate this statement.

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, TcD. 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.

Depreciation​ Given the choice, would a firm prefer to use MACRS depreciation or straight-line depreciation? Why?

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.

Opportunity Cost ​In the context of capital budgeting, what is an opportunity cost?

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 it.

Net Working Capital ​In our capital budgeting examples, we assumed that a firm would recover all of the working capital it invested in a project. Is this a reasonable assumption? When might it not be valid?

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.

Incremental Cash Flows​ Your company currently produces and sells steel shaft golf clubs. The board of directors wants you to consider the introduction of a new line of titanium bubble woods with graphite shafts. Which of the following costs are irrelevant? a.​Land you already own that will be used for the project, but otherwise will be sold for its market value of $700,000. b.​A $300,000 drop in your sales of steel shaft clubs if the titanium woods with graphite shafts are introduced. c.​$200,000 spent on research and development last year on graphite shafts.

Item (a) is a relevant cost because the opportunity to sell the land is lost if the new golf club is produced. Item (b) is also relevant because the firm must take into account the erosion of sales of existing products when a new product is introduced. If the firm produces the new club, the earnings from the existing clubs will decrease, effectively creating a cost that must be included in the decision. Item (c) is irrelevant because the costs of research and development are sunk costs. Decisions made in the past cannot be changed. They are not relevant to the production of the new club.

Stand-Alone Principle Suppose a financial manager is quoted as saying, "Our firm uses the stand-alone principle. Since we treat projects like minifirms in our evaluation process, we include financing costs because they are relevant at the firm level." Critically evaluate this statement.

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 irrelevant in the analysis of a project's incremental cash flows according to the stand-alone principle.

Capital Budgeting​Porsche was one of the last manufacturers to enter the sports utility vehicle market. Why would one company decide to proceed with a product when other companies, at least initially, decide not to enter the market?

One company may be able to produce at lower incremental cost or market better. Also, of course, one of the two may have made a mistake!

Capital Budgeting​In evaluating the Cayenne, what do you think Porsche needs to assume regarding the substantial profit margins that exist in this market? Do you think they were able to maintain this profit margin as the market became more competitive, or would Porsche be able to maintain the profit margin because of its image and the performance of the Cayenne?

Porsche would recognize that the outsized profits would dwindle as more products come to market and competition becomes more intense.

Equivalent Annual Cost ​When is EAC analysis appropriate for comparing two or more projects? Why is this method used? Are there any implicit assumptions required by this method that you find troubling? Explain.

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 when 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 alter the project cash flows.

Capital Budgeting Considerations ​A major college textbook publisher has an existing finance textbook. The publisher is debating whether to produce an "essentialized" version, meaning a shorter (and lower-priced) book. What are some of the considerations that should come into play? To answer the next three questions, refer to the following example. In 2003, Porsche unveiled its new sports utility vehicle (SUV), the Cayenne. With a price tag of over $40,000, the Cayenne goes from zero to 62 mph in 8.5 seconds. Porsche's decision to enter the SUV market was in response to the runaway success of other high-priced SUVs such as the Mercedes-Benz M class. Vehicles in this class had generated years of very high profits. The Cayenne certainly spiced up the market, and, in 2006, Porsche introduced the Cayenne Turbo S, which goes from zero to 60 mph in 4.8 seconds and has a top speed of 168 mph. The base price for the Cayenne Turbo in 2018? Almost $125,000! Some analysts questioned Porsche's entry into the luxury SUV market. The analysts were concerned because not only was Porsche a late entry into the market, but also the introduction of the Cayenne might damage Porsche's reputation as a maker of high-performance automobiles.

There are two particularly important considerations. The first is erosion. Will the "essentialized" book 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 the used product.

Incremental Cash Flows​ Which of the following should be treated as an incremental cash flow when computing the NPV of an investment? a.​A reduction in the sales of a company's other products caused by the investment. b.​An expenditure on plant and equipment that has not yet been made and will be made only if the project is accepted. c.​Costs of research and development undertaken in connection with the product during the past three years. d.​Annual depreciation expense from the investment. e.​Dividend payments by the firm. f.​The resale value of plant and equipment at the end of the project's life. g.​Salary and medical costs for production personnel who will be employed only if the project is accepted.

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. However, if these expenditures have already occurred (and cannot be recaptured through a sale of the plant and equipment), they are sunk costs and are not included as incremental cash flows. c. No, the research and development costs should not be treated as incremental cash flows. The costs of research and development undertaken on the product during the past three years are sunk costs and should not be included in the evaluation of the project. Decisions made and costs incurred in the past cannot be changed. They should not affect the decision to accept or reject the project. d. Yes, the annual depreciation expense must be taken into account when calculating the cash flows related to a given project. While depreciation is not a cash expense that directly affects cash flow, it decreases a firm's net income and hence lowers its tax bill for the year. Because of this depreciation tax shield, the firm has more cash on hand at the end of the year than it would have had without expensing depreciation. e. No, dividend payments should not be treated as incremental cash flows. A firm's decision to pay or not pay dividends is independent of the decision to accept or reject any given investment project. For this reason, dividends are not an incremental cash flow to a given project. Dividend policy is discussed in more detail in later chapters. f. Yes, the resale value of plant and equipment at the end of a project's life should be treated as an incremental cash flow. The price at which the firm sells the equipment is a cash inflow, and any difference between the book value of the equipment and its sale price will create accounting gains or losses that result in either a tax credit or liability. g. Yes, salary and medical costs for production employees hired for a project should be treated as incremental cash flows. The salaries of all personnel connected to the project must be included as costs of that project.