Principles of Managerial Finance

382 PART 3 Long-Term Investment Decisions

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than the after-tax proceeds expected from the old machine had it been

retained and liquidated at the end of year 6.

c. An asset that requires an initial investment of $2 million and will yield

annual operating cash inflows of $300,000 for each of the next 10 years.

Operating cash outlays will be $20,000 for each year except year 6,

when an overhaul requiring an additional cash outlay of $500,000 will be

required. The asset’s liquidation value at the end of year 10 is expected to

be $0.

8–4 Expansion versus replacement cash flows Edison Systems has estimated the

cash flows over the 5-year lives for two projects, A and B. These cash flows are

summarized in the following table.

a. If project A were actually a replacementfor project B and if the $12,000 ini-

tial investment shown for project B were the after-tax cash inflow expected

from liquidating it, what would be the relevant cash flows for this replace-

ment decision?

b. How can an expansion decisionsuch as project A be viewed as a special form

of a replacement decision? Explain.

8–5 Sunk costs and opportunity costs Masters Golf Products, Inc., spent 3 years

and $1,000,000 to develop its new line of club heads to replace a line that is

becoming obsolete. In order to begin manufacturing them, the company will

have to invest $1,800,000 in new equipment. The new clubs are expected to gen-

erate an increase in operating cash inflows of $750,000 per year for the next 10

years. The company has determined that the existing line could be sold to a com-

petitor for $250,000.

a. How should the $1,000,000 in development costs be classified?

b. How should the $250,000 sale price for the existing line be classified?

c. Depict all of the known relevant cash flows on a time line.

8–6 Sunk costs and opportunity costs Covol Industries is developing the relevant

cash flows associated with the proposed replacement of an existing machine tool

with a new, technologically advanced one. Given the following costs related to

the proposed project, explain whether each would be treated as a sunk costor

an opportunity costin developing the relevant cash flows associated with the

proposed replacement decision.

Project A Project B

Initial investment $40,000 $12,000a

Year Operating cash inflows

1 $10,000 $ 6,000

2 12,000 6,000

3 14,000 6,000

4 16,000 6,000

5 10,000 6,000

aAfter-tax cash inflow expected from liquidation.