Cape Cod Cranberries will finance a new organic juice production facility with a $10,000,000 bond issue. Interest on the bonds will be $637,500 per year for the life of the project. Should the interest payments be subtracted from the project's incremental cash flows?
Answer: The cost of interest is implicitly built in to the project's cost of capital which will be used to discount the cash flows to their present value. If interest were subtracted from the expected cash flow, it would be counted twice and the project unfairly penalized.
Cape Cod Cranberries is evaluating the introduction of a new line of organic cranberry products. Market research suggests that approximates 1/3 of sales of the new products will come at the expense of existing product lines. How should this "cannibalization effect" be incorporated into the analysis.
Answer: Incremental cash flows are determined by subtracting firm cash flows without the project from firm cash flows with the project. If lower sales of existing products are a direct result of introducing the new products, the company should deduct the lost cash flows from expected cash flows from the new products. (Some students may argue that the sales of non-organic products might eventually have been lost to competition in any case.)
Anderson-EOG Inc. is evaluating the construction of a gas pipeline to bring natural gas from Western New York state to New York City. The controller argues that depreciation has to be included among the expenses. The Treasurer argues that depreciation is irrelevant because it does not affect cash flow. Who is correct?
Answer: Both are partially right and partially wrong. Depreciation is not a cash expense, but it does affect taxable income and therefore taxes. Since taxes affect cash flow, depreciation must be subtracted to arrive at taxable income, then added back in to arrive at operating cash flow.
Anderson-EOG Inc. is evaluating the construction of a gas pipeline to bring natural gas from Western New York state to New York City. The controller argues that every project of the company has to absorb a portion of administrative overhead including corporate headquarters and executive salaries. The Treasurer argues that these costs are irrelevant because they are merely being shifted from part of the company to another. Who is correct?
Answer: Both are partially right and partially wrong. Costs are only relevant to the analysis if they affect the equation Incremental Project Cash Flows = (Firm Cash Flows with the Project) - (Firm Cash Flows without the Project). Executive salaries would be relevant, for example, if a new person is hired to manage the project or if someone is paid more to accept the additional responsibility.
Briefly explain why each of the following should or should not be considered in forecasting incremental cash flows from a project:
a. The cost of building a prototype of a new product to see if it was feasible.
b. Market research suggests that after buying a company's "smart phone" customers will begin to buy more of the same company's notebook computers.
c. A company decides to use existing space for storage. The company could have rented the space to another business for $2,500 a month.
Answer:
a. The cost of building the prototype is a sunk cost. It will not go away if the decision is not to go ahead with the new product, therefore it is not relevant to the decision.
a. The cost of building the prototype is a sunk cost. It will not go away if the decision is not to go ahead with the new product, therefore it is not relevant to the decision.
b. If the company expects additional sales of an existing product as a result of introducing a new product, it should consider those sales as it forecasts incremental cash flows from the project.
c. The foregone rent is an example of opportunity cost. It is easier to forecast than most cash flows and should definitely be considered.
