372 Part 4 Investing in Long-Term Assets: Capital Budgeting
and reconsider the project before the $150 had been spent, we would see that the
project should be rejected. However, we can’t back up—at this point, we can
either abandon the project or spend $1,000 and go forward with it. If we go for-
ward, we will receive an incremental NPV of $78.82, which would reduce the loss
from !$150 to !$71.18.12-2e Other Changes to the Inputs
Variables other than depreciation also could be varied, and these changes would
alter the calculated cash! ows and thus NPV and IRR. For example, we could
increase or decrease the projected unit sales, the sales price, the variable and/or
the " xed costs, the initial investment cost, the working capital requirements, the
salvage value, and even the tax rate if we thought Congress was likely to raise or
lower taxes. Such changes could be made easily in an Excel model, making it pos-
sible to see the resulting changes in NPV and IRR immediately. This is called
sensitivity analysis, and we discuss it later in the chapter when we take up proce-
dures for measuring projects’ risks.SEL
F^ TEST In what ways is the setup for " nding a project’s cash! ows similar to the
projected income statements for a new single-product " rm? In what ways
would the two statements be di# erent? (One would! nd cash " ows; the
other, net income.)
Would a project’s NPV for a typical " rm be higher or lower if the " rm used
accelerated rather than straight-line depreciation? Why?
How could the analysis in Table 12-1 be modi" ed to consider cannibalization,
opportunity costs, and sunk costs?
Why does working capital appear as both a negative and a positive number
in Table 12-1?12-3 REPLACEMENT ANALYSIS
2
In the last section, we assumed that Project S was an entirely new project. So all
of its cash! ows were incremental—they occurred only if the " rm accepted the
project. This is true for expansion projects; but for replacement projects, we must
" nd cash! ow differentials between the new and old projects and these differentials
are the incremental! ows that we analyze.
We evaluate a replacement decision in Table 12-2, which is set up much like
Table 12-1, but with data on both a new highly ef" cient machine (which will be
depreciated on an accelerated basis) and the old machine (which is depreciated on
a straight-line basis). Here we " nd the " rm’s cash! ows when it continues using
the old machine, then the cash! ows when it decides to use the new one. Finally,
we subtract the old! ows from the new to arrive at the incremental cash! ows. We
used Excel to do the analysis; but again, we could have used a calculator or pencil
and paper. Here are the key inputs used in the analysis. No additional working
capital is needed.(^2) This section is somewhat technical, but it can be omitted without loss of continuity.