Answers to Concepts Review and Critical Thinking Questions
1. In this context, an opportunity cost refers to the value of an asset or other input that will be used in a project. The relevant cost is what the asset or input is actually worth today, not, for example, what it cost to acquire.
2. For tax purposes, a firm would choose MACRS because it provides for larger depreciation deductions earlier. These larger deductions reduce taxes, but have no other cash consequences. Notice that the choice between MACRS and straight-line is purely a time value issue; the total depreciation is the same, only the timing differs.
3. It’s probably only a mild over-simplification. Current ...view middle of the document...
The first is erosion. Will the essentialized book simply displace copies of the existing book that would have otherwise been sold? This is of special concern given the lower price. The second consideration is competition. Will other publishers step in and produce such a product? If so, then any erosion is much less relevant. A particular concern to book publishers (and producers of a variety of other product types) is that the publisher only makes money from the sale of new books. Thus, it is important to examine whether the new book would displace sales of used books (good from the publisher’s perspective) or new books (not good). The concern arises any time that there is an active market for used product.
7. This market was heating up rapidly, and a number of other manufacturers were planning competing products.
8. One company may be able to produce at lower incremental cost or market better. For example, Porsche may have been able to retool existing production more cheaply, and Porsche also has a larger dealer network. Also, of course, one of the two may have made a mistake!
9. Porsche would recognize that the outsized profits would dwindle as more products come to market and competition becomes more intense.
10. With a sensitivity analysis, one variable is examined over a broad range of values. With a scenario analysis, all variables are examined for a limited range of values.
11. It is true that if average revenue is less than average cost, the firm is losing money. This much of the statement is therefore correct. At the margin, however, accepting a project with a marginal revenue in excess of its marginal cost clearly acts to increase operating cash flow.
12. The implication is that they will face hard capital rationing.
13. Forecasting risk is the risk that a poor decision is made because of errors in projected cash flows.
The danger is greatest with a new project because the cash flows are probably harder to predict.
14. The option to abandon reflects our ability to reallocate assets if we find our initial estimates were
too optimistic. The option to expand reflects our ability to increase cash flows from a project if we
find our initial estimates were too pessimistic. Since the option to expand can increase cash flows
and the option to abandon reduces losses, failing to consider these two options will generally lead us
to underestimate a project’s NPV.
Solutions to Questions and Problems
NOTE: All end-of-chapter problems were solved using a spreadsheet. Many problems require multiple steps. Due to space and readability constraints, when these intermediate steps are included in this solutions manual, rounding may appear to have occurred. However, the final answer for each problem is found without rounding during any step in the problem.
1. The $7 million acquisition cost of the land six years ago is a sunk cost. The $8.1 million current aftertax value of the land is an...