Ross et al.: Fundamentals
of Corporate Finance, Sixth
Edition, Alternate EditionIV. Capital Budgeting 10. Making Capital
Investment Decisions© The McGraw−Hill^343
Companies, 2002today (net of any selling costs) because this is the amount that we give up by using the
mill instead of selling it.^2Side Effects
Remember that the incremental cash flows for a project include all the resulting changes
in the firm’sfuture cash flows. It would not be unusual for a project to have side, or
spillover, effects, both good and bad. For example, in 2002, Japanese automaker Nissan
introduced an all new version of its Altima sedan. The new model was larger all around
and, in fact, looked a lot like a freshened-up version of its big brother, the Maxima.
Many observers predicted that some portion of the Altima’s sales would simply come at
the expense of the Maxima. A negative impact on the cash flows of an existing product
from the introduction of a new product is called erosion, and the same general problem
anticipated by Nissan could occur for any multiline consumer product producer or
seller.^3 In this case, the cash flows from the new line should be adjusted downwards to
reflect lost profits on other lines.
In accounting for erosion, it is important to recognize that any sales lost as a result of
launching a new product might be lost anyway because of future competition. Erosion
is only relevant when the sales would not otherwise be lost.
Side effects show up in a lot of different ways. For example, one of Walt Disney’s
concerns when it built Euro Disney was that the new park would drain visitors from the
Florida park, a popular vacation destination for Europeans. To give an example from the
world of professional sports, when the L.A. Lakers signed Shaquille O’Neal, Coca-Cola
Co. decided not to renew a marketing agreement with the Lakers worth an estimated
$1 million a year because Shaq was a high-profile endorser of Pepsi.
There are beneficial spillover effects, of course. For example, you might think that
Hewlett-Packard would have been concerned when the price of a printer that sold for $500
to $600 in 1994 declined to below $100 by 2001, but they weren’t. What HP realized was
that the big money is in the consumables that printer owners buy to keep their printers go-
ing, such as ink-jet cartridges, laser toner cartridges, and special paper. The profit margins
for these products are substantial, reaching as high as 70 percent in some cases.Net Working Capital
Normally, a project will require that the firm invest in net working capital in addition to
long-term assets. For example, a project will generally need some amount of cash on hand
to pay any expenses that arise. In addition, a project will need an initial investment in in-
ventories and accounts receivable (to cover credit sales). Some of the financing for this
will be in the form of amounts owed to suppliers (accounts payable), but the firm will have
to supply the balance. This balance represents the investment in net working capital.
It’s easy to overlook an important feature of net working capital in capital budgeting.
As a project winds down, inventories are sold, receivables are collected, bills are paid, and
cash balances can be drawn down. These activities free up the net working capital origi-
nally invested. So, the firm’s investment in project net working capital closely resembles
a loan. The firm supplies working capital at the beginning and recovers it towards the end.314 PART FOUR Capital Budgeting
(^2) If the asset in question is unique, then the opportunity cost might be higher because there might be other
valuable projects we could undertake that would use it. However, if the asset in question is of a type that is
routinely bought and sold (a used car, perhaps), then the opportunity cost is always the going price in the
market because that is the cost of buying another similar asset.
(^3) More colorfully, erosion is sometimes called piracyor cannibalism.
erosion
The cash flows of a new
project that come at the
expense of a firm’s
existing projects.