Case Study 12a

Case 12A: 6-13-2013

Questions: 1, 2, 3, 5, 6, 7, 9, 10, 11, 12

1. Define the term “incremental cash flow.” Since the project will be financed in part by debt, should the cash flow statement include interest expenses? Explain

An incremental cash flow is additional cash flow that results directly from taking on an investment in a new project. Incremental cash flows allow a company to determine whether or not it is worth their time and money to invest. A positive incremental cash flow would be a good indicator that the company should move forward with the project. The project’s statement of cash flows should not include the interest expense because it is an irrelevant component of the statement, as are sunk costs related to the R&D of firms. Interest expense is a financing cost, not an operating cost and it is used in the cost of capital. To explain in detail, because we already accounted for the “X” percentage of cost of capital (WACC) to discount the cash flows, adding interest expense will just cause us to deduct capital cost twice.

2. Should the $150,000 test marketing cost be included in the analysis? Explain

The $150,000 test marketing cost is actually considered to be a sunk cost, not an incremental cash flow. As mentioned in the question above, sunk costs should not be included in the cash flow analysis. Whether or not the test marketing cost is included would not have an effect on the company’s decision to accept or reject the project.

3. Suppose the Cranberry Association actually made a firm offer the lease the lite juice production site for $25,000 a year for 20 years. How should that information be incorporated into the analysis?

5. Should the erosion of profits from regular cranapple sales be charged to the lite cranapple project? What is management believed that, if Cranfield did not introduce the lite product, a competing firm very likely would, so regular cranapple sales would be adversely affected regardless of whether the...