PArT 3: CAPITAL BUDGETING
are acceptable investments and provide equal quality service. The company assumes that the
replacement and maintenance costs for both projects will remain unchanged over time.
a Find the NPV of each project over its
life.
b Which project would you recommend,
based on your finding in part (a)?
What is wrong with choosing the best
project, based on its NPV?c Use the equivalent annual cost (EAC)
method to compare the two projects.
d Which project would you recommend,
based on your finding in part
(c)? Compare and contrast this
recommendation with the one you
gave in part (b).QUESTIONS
Q10-1 In capital budgeting analysis, why do we
focus on cash flow rather than accounting
profit?Q10-2 To finance a certain project, a company
must borrow money at 10% interest. How
should it treat interest payments when it
analyses the project’s cash flows?
Q10-3 Does depreciation affect cash flow in a
positive or negative manner? From a net
present value (NPV) perspective, why is
accelerated depreciation preferable? Is
it acceptable to utilise one depreciation
method for tax purposes and another
for financial reporting purposes? Which
method is relevant for determining project
cash flows?
Q10-4 In what sense does an increase in accounts
payable represent a cash inflow?
Q10-5 List several ways to estimate a project’s
terminal value.Q10-6 What are the tax consequences of selling
an investment asset for more than its book
value? Does this have an effect on project
cash flows that must be accounted for?
What is the effect if the asset is sold for less
than its book value?
Q10-7 Why must incremental, after-tax, cash
flows, rather than total cash flows, be
evaluated in project analysis?
Q10-8 Differentiate between sunk costs and
opportunity costs. Which of these costs
should be included in incremental cash
flows and which should be excluded?
Q10-9 Why is it important to consider
cannibalisation in situations where a
company is considering adding substitute
products to its product line?Q10-10 Before entering graduate school, a
student estimated the value of earning an
MBA at $300,000. Based on that analysis,
the student decided to go back to
school. After completing the first year, the
student ran the NPV calculations again.
How would you expect the NPV to look
after the student has completed one year
of the program? Specifically, what portion
of the analysis must be different than it
was the year before?Q10-11 Furry Taxidermy Ltd (FT) operates a chain
of taxidermy shops across NSW, with a
handful of locations in Victoria. A rival
company, Heads Up Ltd, has a few NSW-
based locations, but most of its shops
are located in Victoria. FT and Heads Up
decide to consolidate their operations
by trading ownership of a few locations.
FT will acquire four Heads Up locations
in NSW, and will relinquish control of
its Victorian locations in exchange. No
cash changes hands up-front. Does this
mean that an analyst working for either
company can evaluate the merits of this
deal by assuming that the project has no
initial cash outlay? Explain.
Q10-12 What is the only relevant decision for
independent projects if an unlimited capital
budget exists? How does your response
change if the projects are mutually
exclusive? How does your response change
if the company faces capital rationing?
Q10-13 Explain why the equivalent annual cost
(EAC) method helps companies evaluate
alternative investments with unequal
lives.
Q10-14 Why isn’t excess capacity free?