Introduction to Corporate Finance

10: Cash Flow and Capital Budgeting

4 What are sunk costs and cannibalisation, and do they affect the process of determining a proposed

investment’s incremental cash flows?

5 A real-estate development company owns a fully leased 40-storey office building. A tenant recently

moved its offices out of two storeys of the building, leaving the space temporarily vacant. If the

real-estate company considers moving its own offices into this 40-storey office building, what cost

should it assign for the space? Is the cost of the vacant space zero, because the company paid for

the building long ago, is it a cost that is sunk, or is there an incremental opportunity cost?

6 Suppose that an analyst makes a mistake and calculates the NPV of an investment project by

discounting the project’s contribution to net income each year rather than by discounting its

relevant cash flows. Would you expect the NPV based on net income to be higher or lower than the

NPV calculated using the relevant cash flows?

CONCEPT REVIEW QUESTIONS 10-2

10-3 CASH FLOWS FOr PrOTECT IT LTD

Protect IT Ltd is a (fictitious) company that makes protective cases for smartphones such as the iPhone.

The company is considering a proposal to expand its product selection to include protective covers for

tablet devices such as the iPad, and so far the company has spent $10,000 analysing the potential market

for such a product. Management believes that many purchasers of mobile phone cases will also buy

protective covers for tablets, and so the company has a built-in clientele for the new product line. If the

company decides to undertake this project, it will begin selling new products next month, when its new

fiscal year begins. The company would therefore make the required investment before the end of the

current fiscal year (year 0). The company accepts projects with positive NPVs, and it uses a 15% discount

rate to calculate NPV.

Up-front costs include $50,000 in computer equipment that the company will depreciate for five

years on a straight-line basis starting in year 1. Protect IT must also make an immediate investment of

$4,500 in inventory, though $2,500 of that can be purchased on credit. For transactions purposes, the

company plans to increase its cash balance by $1,000 immediately. Managers expect the average selling

price of its new tablet covers to be $13.50, and they expect that price to remain constant indefinitely.

Protect IT expects to finance this investment using the cash flow generated from its existing business.

Managers expect unit sales volume to start at 4,500 and to grow rapidly for a few years. In the long

run, they predict that unit sales will increase by 4% per year. Cost of goods sold will equal 72% of sales

revenue, with selling, general and administrative expenses at 10% of sales.

As sales grow, Protect IT will hold slightly larger cash balances and make additional investments

in inventory and receivables. Each year, accounts receivable will be equivalent to one-month’s sales,

and inventory balances will be about 12.5% of sales. We assume that after the initial purchase of new

computers, no additional fixed asset investments will be necessary. In addition, Protect IT’s suppliers

will provide trade credit on terms such that the accounts payable balance will equal about 10% of cost

of goods sold for each year.

LO10.4

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CONCEPTS

How would you explain NPV

calculations to a non-financial

manager?

thinking cap

question