Solution to Case 103
IF THE COAT FITS WEAR IT – TEACHING NOTE
Questions
1. Your supervisor, Vic Gonzales, has asked you to prepare a capital budgeting report indicating whether ISGC should replace the existing machine or not. Indicate how would you proceed (without making any calculations)?
I would estimate the incremental cash flows over the economic life of the new machine, taking into consideration the after-tax salvage values of the old and new machine respectively. Changes in net working capital would be figured in as well. For the terminal year, we would assume that the net working capital is recovered and treat it as a cash inflow.
2. Explain the relevance of incremental cash flows, sunk costs, and incidental costs in the context of this case.
Since this case involves the decision of whether or not to replace an existing machine, it is important to take into consideration only the difference between the various revenue and expense items that would occur if the old machine were replaced. These are called incremental cash flows. Sunk costs are not relevant in this case. An example of a sunk cost would be a consulting fee paid by the firm to come up with suggestions regarding output efficiency. Incidental costs are those that affect some other area or aspect of the firm’s business. For example, if as a result of the new machine, sales of some other product of the company suffered, the reduced revenues should be considered as a cash outflow for the new project.
3. As is often the case, the marketing department has overestimated the annual sales growth. How can more conservative ...