Principles of Managerial Finance

362 PART 3 Long-Term Investment Decisions

opportunity costs
Cash flows that could be realized
from the best alternative use of
an owned asset.

Initial

investment

Initial investment

needed to acquire

new asset

After-tax cash inflows

from liquidation

of old asset

 

Operating

cash inflows

Operating cash

inflows from

new asset

Operating cash

inflows from

old asset

 

Terminal

cash flow

After-tax cash flows

from termination

of new asset

After-tax cash flows

from termination

of old asset

 

FIGURE 8.4

Relevant Cash Flows for
Replacement Decisions
Calculation of the three
components of relevant cash
flow for a replacement
decision

sunk costs
Cash outlays that have already
been made (past outlays) and
therefore have no effect on the
cash flows relevant to a current
decision.

the old asset. The operating cash inflows are the difference between the operating

cash inflows from the new asset and those from the old asset. The terminal cash

flow is the difference between the after-tax cash flows expected upon termination

of the new and the old assets. These relationships are shown in Figure 8.4.

Actually, all capital budgeting decisions can be viewed as replacement deci-

sions. Expansion decisions are merely replacement decisions in which all cash

flows from the old asset are zero. In light of this fact, this chapter focuses primar-

ily on replacement decisions.

Sunk Costs and Opportunity Costs

When estimating the relevant cash flows associated with a proposed capital

expenditure, the firm must recognize any sunk costsand opportunity costs.These

costs are easy to mishandle or ignore, particularly when determining a project’s

incremental cash flows. Sunk costsare cash outlays that have already been made

(past outlays) and therefore have no effect on the cash flows relevant to the cur-

rent decision. As a result, sunk costs should not be included in a project’s incre-

mental cash flows.

Opportunity costsare cash flows that could be realized from the best alterna-

tive use of an owned asset. They therefore represent cash flows that will not be

realizedas a result of employing that asset in the proposed project. Because of

this, any opportunity costs should be included as cash outflows when one is

determining a project’s incremental cash flows.

EXAMPLE Jankow Equipment is considering renewing its drill press X12, which it purchased

3 years earlier for $237,000, by retrofitting it with the computerized control sys-

tem from an obsolete piece of equipment it owns. The obsolete equipment could

be sold today for a high bid of $42,000, but without its computerized control sys-

tem, it would be worth nothing. Jankow is in the process of estimating the labor