Question

1. From the following list, discuss which are incremental cash flows and therefore should be included in your capital investment calculations.

a.. A firm has a parcel of land that can be used for a new plant site, be sold, or be used for agricultural purposes.

           

b.   A new product will generate new sales, but some of those new sales will be from customers who switch from one of the firm’s current products.

           

c.   The interest paid on funds borrowed to finance a project.

           

d.   A firm has spent $2 million on R&D associated with a new product. These costs have been expensed for tax purposes, and they cannot be recovered if the new project is rejected.

           

e.   A firm can produce a new product, and the existence of that product will stimulate sales of some of the firm’s other products.

           

f.    The use of high quality factory floor space that is currently unused but is available for production of other products.

           

g.   Administrative expenses from office staff who do payroll for the firm.

           

h.   Shipping and installation costs associated with preparing the machine to be used to produce the new product.

           

i.    The cost of a marketing study completed last year related to the new product. This costs was expensed for tax purposes last year.                                

           

j.    Depreciation tax effects of the capital investment of the project.

                       

2. Explain to your grandfather why he should be using NPV instead of payback to make the capital investment decisions at his firm.

3. Richards Tree Farm, Ltd. has branched into gardening over the years and is now considering adding patio furniture to its product lineup. Currently, the area where the patio furniture is to be displayed is a vacant slab of concrete attached to the indoor shop. The company originally paid $8,500 to put in the slab of concrete three years ago. It would now cost $12,000 to put in the same slab of concrete. It is estimated that the adjustments to the area would cost $25,000 but could be depreciated to zero over 5 years. The overhead allocation to the new project is expected to be $5000 per year. The new sales for the patio furniture are expected to be $40,000 with cost of goods sold of $30,000. However, it is expected that the sales from gardening supplies will increase by $8000 (COGS for gardening supplies is $6000). The patio furniture project is estimated to last 5 years. The marginal tax rate is 40% and the opportunity cost of capital is 12%. Should Richards Tree Farm proceed with the project?

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Answer 1

As per rules I am answering the first 4 subparts of the question

1: the opportunity cost of the land will be taken into account while assessing the new project. The market value of the land will be considered as negative incremental cash flows.

2: the new sales will be incremental cash inflows but this amount has to be reduced by the loss of sales of the current products.

3: interest paid on funds borrowed are not considered cash flows because this is considered in the discount rate used for assessing the project.

4: the amount spent on research and development is a sunk cost and hence it should not be considered as incremental cash flows.