Principles of Managerial Finance

(Dana P.) #1

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.
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