Robert Montoya

Case Presentation 14 (A)

1. Incremental cash flow is the additional cash that an organization receives from taking on a new project. A positive incremental cash flow means that the company's cash flow will increase with the acceptance of the project.

In computing for the cost of capital, calculations must include the cost of debt, cost of preferred stocks, and cost of common equity. As can be seen in the case, the cost of debt (pre-tax) is 10% with a 40% federal-plus-state tax rate. The cost of common equity is 14%. Computing for the WACC, we get a 10% cost of capital.

Therefore, the cost of borrowing money for the purpose of financing the project is already accounted for. If interest expense is deducted from the operating cash flow and the cash flows were then discounted at the cost of capital, the cost of debt would be double counted. In effect, the net present value of the project will be understated.

2. Only incremental cash flows are considered in a capital budgeting decision. However, a common drawback is counting costs already paid or incurred the liability to pay for in the past. This is what is called a sunk cost.

In this case, the $300,000 spent to rehabilitate facilities should not be included in the analysis. The firm has already paid for this rehabilitation, whether they decide to accept the project or not. The $300,000 should not affect the decision to be made as it has already been incurred in the past.

3. This $30,000 lease on the production site would be treated as an opportunity cost. Therefore, it should be charged against the project cash flows. Opportunity costs are cash flows that can be generated from a company’s assets provided they are not used for the specific project in mind.

In this scenario, the $30,000 a year becomes an opportunity cost because the use of the site for their own wine production would relinquish the amount of this lease. That is, the company could have earned $30,000 a year if they did...