Introduction to Corporate Finance

PArT 3: CAPITAL BUDGETING

If you did not attend school, you would earn $60,000 ($39,000 after taxes ($60,000 × (1.00 – 0.35)))

the first year and $63,000 ($40,950 after taxes ($63,000 × (1.00 – 0.35))) the second year. This is

your opportunity cost of getting an MBA, and it is just as important in the overall calculation as your

out-of-pocket expenses for tuition, fees and books. Though it is still true, given the assumptions of

our example, that the NPV of an MBA is positive, the value of the degree falls substantially once we

recognise opportunity costs. As every MBA student knows, opportunity costs are real, not just hypothetical

numbers from a textbook. Directors of MBA programs all over the world know that MBA applications are

countercyclical. That is, the number of students applying to MBA programs increases during economic

downturns and falls during booms. One plausible explanation of this phenomenon is that potential MBA

students face higher opportunity costs when the economy is strong.

Probably the most common type of opportunity cost encountered in capital budgeting problems

involves the alternative use of an asset owned by a company. Suppose that a company owns raw land that

it purchased some years ago in anticipation of an expansion opportunity. Now the company is ready to

expand by building new facilities on the raw land. Even though the company may have paid for the land

many years ago, using the land for expansion entails an incremental opportunity cost. The opportunity

cost is the cash that would be received if the company sold the land or leased it for another purpose today.

That cost (the cash inflows given up) should be factored into the NPV calculation for the company’s

expansion plans.

10-2c CANNIBALISATION

Incremental cash flows can show up in surprising forms. One type of incremental cash outflow that

companies must be careful to measure when launching a new product is called cannibalisation. This

involves the ‘substitution effect’ that frequently occurs when a company introduces a new product.

Typically, some of the new product’s sales come at the expense of the company’s existing products.

In the food products industry, sales of a low-fat version of a popular product may reduce sales of the

original (presumably, high-fat) version. Some consumers may effectively substitute purchases of the new,

‘improved’ product for purchases of the original product, which has the effect on net of reducing the

incremental cash flows of the new project.^9 Companies carefully consider the incremental cash outflows

from existing product sales that are cannibalised by a newer product.^10

In the next section, we work through an extended example of a capital budgeting project, illustrating

how to apply the principles from this section to calculate the project’s cash flows each year. Before

getting into the details, we want to remind you of the overall picture. Cash flows are important because

they are necessary to calculate a project’s NPV. Estimating the NPV is important because it provides

an estimate of the increase or decrease in shareholder value that will occur if the company invests.

Research has demonstrated the connection between capital investment decisions and shareholder value

by showing that share prices rise on average when companies publicly announce significant new capital

investment programs. This suggests that, on average, companies invest in positive NPV projects.

cannibalisation

Loss of sales of a company’s

existing product when a new

product is introduced

Scott Lee, Texas A&M

University

‘We have found evidence

that the market punishes

companies that were

involved in defense

procurement fraud.’

See the entire interview on

the CourseMate website.

COUrSEMATE
SMArT VIDEO

Source: Cengage Learning

9 But it is even more complicated than that. If this company does not introduce a low-fat product line, a competitor might introduce a low-fat

product, which would reduce sales of high-fat products anyway. Thus, this company needs to consider the incremental cash flows from

introducing a new, low-fat product line relative to what cash flows would be if this company did not introduce low-fat products, considering

that someone else might.

10 On a capital budgeting exam problem, one of our students mentioned that a company needed to be wary that its new product should not

‘cannibalise the existing sales force’. Needless to say, that is not the kind of cannibalisation that we have in mind, although should it occur, it

would certainly represent an incremental cash outflow.