Aswath Damodaran 259
Estimating the Cost of Excess Capacity
! The existing Capacity is 100 , 000 units; the book value of this unit is $ 1
million. The cost of buying a unit with the same capacity is $ 1. 5 million. The
company’s cost of capital is 12 %.
! Current Usage = 50 , 000 ( 50 % of Capacity); 50 % Excess Capacity;
- New Product will use 30 % of Capacity; Sales growth at 5 % a year; CM per unit =
$ 5 /unit
- Current product sales growing at 10 % a year. CM per unit = $ 4 /unit
! Basic Framework
- If I do not take this product, when will I run out of capacity?
- If I take this project, when will I run out of capacity
- When I run out of capacity, what will I do?
- cut back on production: cost is PV of after-tax cash flows from lost sales
- buy new capacity: cost is difference in PV between earlier & later investment
The use of excess capacity in the first year does not create a cost, since there is
an excess capacity of 50%, and only 30% will be used by the new product. It is
the fact that the existing product revenues are growing that will create the cost.
