(i) Opportunity Cost.
Suppose IBM decides to build a new office building in Sao Paulo
on some land it bought 10 years ago. IBM must include the cost of the land in
calculating the value of undertaking the project. Also, this cost must be based on the
current market value of the land, not the price it paid 10 years ago. This example
demonstrates a more general rule. Project costs must include the true economic cost of
any resource required for the project, regardless of whether the firm already owns the
resource or has to go out and acquire it. This true cost is the opportunity cost, the
maximum amount of cash the asset could generate for the firm should it be sold or put
to some other productive use.
(ii) Sales Creation.
Black & Decker, the U.S. power tool company, significantly
expanded its exports to Europe after investing in European production facilities that
gave it a strong local market position in several product lines. Similarly, GM’s auto
plants in Britain use parts made by its U.S. plants, parts that would not otherwise be
sold if GM’s British plants disappeared. In both cases, an investment either created or
was expected to create additional sales for existing products. Thus, sales creation is
the opposite of cannibalization.
(iii) Cannibalization.
When Honda introduced its Acura line of cars, some customers
switched their purchases from the Honda Accord to the new models. This example
illustrates the phenomenon known as cannibalization, a new product taking sales
away from the firm’s existing products. Cannibalization also occurs when a firm
builds a plant overseas and winds up substituting foreign production for parent
company exports. To the extent that sales of a new product or plant just replace other
corporate sales, the new project’s estimated profits must be reduced by the earnings
on the lost sales.
(iv) Accounting for Intangible Benefits.
Related to the choice of an incorrect base case
is the problem of incorporating intangible benefits in the capital-budgeting process.
Intangibles such as better quality, faster time to market, quicker and less error-prone
order processing, and higher customer satisfaction can have tangible impacts on
corporate cash flows, even if they cannot be measured precisely. Similarly, many
investments provide intangible benefits in the form of valuable learning experiences
and a broader knowledge base. For example, investing in foreign markets can sharpen
competitive skills: It exposes companies to tough foreign competition; it enables them
to size up new products being developed overseas and figure out how to compete with
them before these products show up in the home market; and it can aid in tracking
emerging technologies to transfer back home.
(v) Getting the Base Case Right.
In general, a project’s incremental cash flows can be
found only by subtracting worldwide corporate cash flows without the investment—
the base case—from post investment corporate cash flows. To come up with a
realistic base case, and thus a reasonable estimate of incremental cash flows,
managers must ask the key question, ‘What will happen if we don’t make this
investment?’’ Failure to heed this question led General Motors during the 1970s to
slight investment in small cars despite the Japanese challenge; small cars looked less
profitable than GM’s then-current mix of cars. As a result, Toyota, Nissan, and other
Japanese automakers were able to expand and eventually threaten GM’s base
business.
(vi) Fees and Royalties.
Often companies will charge projects for various items such as
legal counsel, power, lighting, heat, rent, research and development, headquarters
staff, management costs, and the like. These charges appear in the form of fees and
royalties. They are costs to the project, but they are a benefit from the standpoint of
the parent firm.
(vii) Transfer Pricing. By raising the price at which a proposed Ford plant in Dearborn,
Michigan, will sell engines to its English subsidiary, Ford can increase the apparent
profitability of the new plant but at the expense of its English affiliate. Similarly, if
Matsushita lowers the price at which its Panasonic division buys microprocessors
from its microelectronics division, the latter’s new semiconductor plant will show a
decline in profitability. These examples demonstrate that the transfer prices at which
goods and services are traded internally can significantly distort the profitability of a
proposed investment. Whenever possible, the prices used to evaluate project inputs or
outputs should be market prices.
(viii)
maurice.mutuku answered the question on April 25, 2019 at 07:09