Introduction to Corporate Finance

PArT 3: CAPITAL BUDGETING

Knowing that it will replace the old device with the improved device in three years, the company can

simply discount cash flows for three years:

NPVA =$12,000+++=

$1,500

1.07

$1,500

1.07

$1,500

1.07

123 $15,936

NPVB (^) =$14, 000 +++=
$1,200
1.07
$1,200
1.07
$1,200
1.07
123 $17,^149
In this case, the best device to purchase is A rather than B. Remember that B’s primary advantage
was its longevity. In an environment in which technological developments make old machines obsolete,
longevity is not much of an advantage.
10- 4c EXCESS CAPACITY
Companies often operate at less than full capacity. In such situations, managers encourage alternative
uses of the excess capacity because they view it as a free asset. Although it may be true that the marginal
cost of using excess capacity is zero in the very short run, using excess capacity today may accelerate the
need for more capacity in the future. When that is so, to fully account for incremental cash flow effects,
managers should charge the cost of accelerating new capacity development against the current proposal
for using excess capacity. This procedure can be demonstrated by the following example.
example
Imagine a retail department store chain with a regional distribution centre in south-eastern Australia. At the
moment, the distribution centre is not fully utilised. Managers know that in two years, as new stores are built
in the region, the company will have to invest $2 million (cash outflow) to expand the distribution centre’s
warehouse. A proposal surfaces to lease all the excess space in the warehouse for the next two years at a price
that would generate beginning-of-year cash inflow of $125,000 per year. If the company accepts this proposal,
it will have no excess capacity. In order to hold inventory for new stores coming on line in the next few months,
the company will have to begin expansion immediately. The incremental investment in this expansion is the
difference between investing $2 million now versus investing $2 million two years from today. The incremental
cash inflow is, of course, the $125,000 lease cash flows that are received today and one year from today.
Should the company accept this offer? Assuming a 10% discount rate, the NPV of the project is shown as
follows:
NPV (^) $125,000 $2,000,000 $125,000
1.1

$2,000,000

(^12) 1.1

= −++= $108,471

Notice that we treat the $2 million investment in the second year as a cash inflow in this expression. By

building the warehouse today, the company avoids having to spend the money two years later. Even so, the

NPV of leasing excess capacity is negative. However, a clever analyst could propose a counter offer derived

from the following equation:

NPVX

X

$2,000,000

1.1

$2,000,000

1.1

=− ++ 12 =$0

The value of X represents the amount of the lease cash inflow (one received today and the other received

in one year) that would make the company indifferent to the proposal. Solving the equation, we see that if the

lease cash inflows are $181,818, the project NPV equals zero. Therefore, if the company can lease its capacity

for a price above $181,818, it should do so.