Replacement (Cost Cutting) Proposals: Manufacturing RoadBlock Should we invest in new equipment, or keep the existing equipment? What are the incremental cash flows? Information: New Machine Cost $12,000 $3,000 cost savings for 5 years (before tax) Straight Line Depreciation to a value of zero (5 years) Machine will be sold for $2,000 at the end of year 5. NWC decrease of $1,500 now. NWC is a permanent reduction in inventory and is not recovered at the end of the project.

Information: Old Machine Replacement (Cost Cutting) Proposals: Manufacturing RoadBlock (Continue) Information: Old Machine The machine was originally purchased 5 years ago for $5,000. It is being depreciated to a value of zero on a straight line basis over 10 years. The current book value is $2,500. If the new machine is purchased, the old machine will be sold for $1,000. No salvage value in 5 years. Marginal Tax rate is 40% and average tax rate is 31 percent. Cost of capital is 10%

Items to consider in evaluating Capital Budgeting cases Inconsistencies in Cash Flow estimation may arise from: 1. Differences in expectations for economy 2. Different attitudes toward risk 3. Performance criterion Bias in CF estimation may come from: 1. Optimism/Pessimism 2. Exaggeration/Understatement Economic Rents arise from: 1. Monopoly Power 2. Differentiated Skill Do not accept that statement that a project has a positive NPV unless if you can state where your comparative advantage is.

Points to remember in valuing projects 1. Anticipated and prolonged economic rents are uncommon. High economic rents (NPV) usually attract competitors; it is therefore important to estimate the timing of competitors entry into the market. 2. Successive generations of technology tend to reduce the value of earlier generation assets. This does not mean that we should delay development of a new product generation. Remember, a growth industry has no mercy on laggards. 3. Identify your firms competitive advantage and capitalize on it. 4. The economic rent to a more efficient producer can be thought of as the difference between its costs and the costs of a marginal producer.