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c. A, B and G
d. Other



In Practice: Using A Higher Hurdle Rate
Some firms choose what seems to be a more convenient way of selecting projects,
when they face capital rationing ““ they raise the hurdle rate to reflect the severity of the
constraint. If the definition of capital rationing is that a firm cannot take all the positive
net present value projects it faces, raising the hurdle rate sufficiently will ensure that the
problem is resolved or at least is hidden. For instance, assume that a firm has a true cost
of capital of 12%,5 a capital rationing constraint of $100 million, and positive net present
value projects requiring an initial investment of $250 million. At a higher cost of capital,
fewer projects will have positive net present values. At some cost of capital, say 18%, the



5 By true cost of capital, we mean a cost of capital that reflects the riskiness of the firm and its financing
mix.
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positive net present value projects remaining will require an initial investment of $100
million or less.
There are problems which may result from building the capital rationing
constraint into the cost of capital. First, once the adjustment has been made, the firm may
fail to correct it for shifts in the severity of the constraint. Thus, a small firm may adjust
its cost of capital from 12% to 18% to reflect a severe capital rationing constraint. As the
firm gets larger, the constraint will generally become less restrictive, but the firm may not
decrease its cost of capital accordingly. Second, increasing the discount rate will yield net
present values that do not convey the same information as those computed using the
correct discount rates. The net present value of a project, estimated using the right
discount rate, is the value added to the firm by investing in that project; the adjusted
present value estimated using an adjusted discount rate cannot be read the same way.
Finally, adjusting the discount rate penalizes all projects equally, whether they are capital
intensive or not.


Side Costs from Projects
In much of the project analyses that we have presented in this chapter, we have
assumed that the resources needed for a project are newly acquired; this includes not only
the building and the equipment, but also the personnel needed to get the project going.
For most businesses considering new projects, this is an unrealistic assumption, however,
since many of the resources used on these
Opportunity Cost: This is the cost assigned
projects are already part of the business and
to a project resource that is already owned by the
will just be transferred to the new project.
firm. It is based upon the next best alternative use.
When a business uses such resources, there
is the potential for an opportunity cost ““
the cost created for the rest of the business as a consequence of this project. This
opportunity cost may be a significant portion of the total investment needed on a project.

1. Opportunity Costs
In much of the project analyses that we have presented in this chapter, we have
assumed that the resources needed for a project are newly acquired; this includes not only
building and equipment, but also the personnel needed to get the project going. For most
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businesses considering new projects, this is an unrealistic assumption, however, since
many of the resources used on these projects are already part of the business and will just
be transferred to the new project. When a business uses such resources, there is the
potential for an opportunity cost ““ the cost created for the rest of the business as a
consequence of using existing resources in this project instead of elsewhere. This
opportunity cost may be a significant portion of the total investment needed on a project.
The opportunity cost for a resource is simplest to estimate when there is a current
alternative use for the resource, and we can estimate the cash flows lost by using the
resource on the project. It becomes more complicated when the resource has not a current
use but potential future uses. In that case, we have to estimate the cash flows foregone on
those future uses to estimate the opportunity costs.

Resource with a current alternative use
The general framework for analyzing opportunity costs begins by asking the question
“ Is there any other use for this resource right now?” For many resources, there will be an
alternative use if the project being analyzed is not taken.
The resource might be rented out, in which case the rental revenue is the opportunity

lost by taking this project. For example, if the project is considering the use of a
vacant building owned by the business already, the potential revenue from renting out
this building to an outsider will be the opportunity cost.
The resource could be sold, in which case the sales price, net of any tax liability and

lost depreciation tax benefits, would be the opportunity cost from taking this project.
The resource might be used elsewhere in the firm in which case the cost of replacing

the resource is considered the opportunity cost. Thus, the transfer of experienced
employees from established divisions to a new project creates a cost to these
divisions, which has to be factored into the decision making.
Sometimes, decision makers have to decide whether the opportunity cost will be
estimated based on the lost rental revenue, the foregone sales price or the cost of
replacing the resource. When such a choice has to be made, it is the highest of the costs “
“ that is, the best alternative foregone ““ that should be considered as an opportunity
cost.
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6.4. ˜: Sunk Costs and Opportunity Costs
A colleague argues that resources that a firm owns already should not be considered in
investment analysis, because the cost is a sunk cost. Do you agree?
a. Yes
b. No
How would you reconcile the competing arguments of sunk and opportunity costs?

Illustration 6.8: Estimating the Opportunity Cost for a Resource with a Current
Alternative Use
Working again with the Bookscape Online example, assume that the following
additional information is provided:
While Bookscape Online will employ only two full-time employees, it is estimated

that the additional business associated with on-line ordering, and the administration of
the service itself will add approximately 40 hours of work for the current general
manager of the bookstore. As a consequence, the salary of the general manager will
be increased from $ 100,000 to $ 120,000 next year; it is expected to grow 5% a year
after that..
It is also estimated that Bookscape Online will utilize an office that is currently used

to store financial records. The records will be moved to a bank vault, which will cost
$ 1000 a year to rent.
The opportunity cost of the addition to the general manager™s workload lies in the
additional salary expenditure that will be incurred as a consequence. Taking the present
value of the after-tax costs (using a 40% tax rate) over the next 5 years, using the cost of
capital of 22.76% estimated in illustration 5.2, yields the estimates in Table 6.6:
Table 6.6: Present Value of Additional Salary Expenses
1 2 3 4
Increase in Salary $20,000 $21,000 $22,050 $23,153
After-tax expense $12,000 $12,600 $13,230 $13,892
Present Value $9,775 $8,361 $7,152 $6,117

The cumulated present value of the costs is $31,046.
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Turning to the second resource ““ the storage space originally used for the
financial record ““ if this project is taken, the opportunity cost is the cost of the bank
vault.
Additional Storage Expenses per year = $1,000
After-tax Additional Storage Expenditure per year = $1,000 (1 - 0.40) = $ 600
PV of After-tax Storage Expenditures for 4 years = $ 600 * PV (A, 22.76%,4 years)
= $ 1,475.48
The opportunity costs estimated for the general manager™s added workload ($
31,046) and the storage space ($1,475) are in present value terms and can be added on to
<$38,893> that we computed as the net present value of Bookscape Online in illustration
5.11.The net present value becomes more negative.
Net present value with opportunity costs = NPV without opportunity costs + Present
value of opportunity costs = -$38.893 - $31,046 - $1,475= - $71,774
The cash flows associated with the opportunity costs could alternatively have
been reflected in the years in which they occur. Thus, the additional salary and storage
expenses could have been added to the operating expenses of the store in each of the 4
years. As table 6.7 indicates, this approach would yield the same net present value and
would have clearly been the appropriate approach if the internal rate of return were to be
calculated.
Table 6.7: Net Present Value with Opportunity Costs “ Alternate Approach
Year Cashflow with opportunity costs Present Value
0 -$1,150,000 -$1,150,000
1 $327,400 $266,705
2 $401,800 $266,633
3 $432,670 $233,890
4 $706,238 $310,998
Net Present Value = -$71,774

Note that this net present value confirms our earlier finding ““this project should not be
taken.

Opportunity Costs of Resources with no Current Alternative Use
In some cases, a resource that is being considered for use in a project will have no
current alternative use but the business will have to forego alternative uses in the future.
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One example would be excess capacity on a machine or a computer. Most firms cannot
lease or sell excess capacity, but using that capacity now for a new product may cause the
businesses to run out of capacity much earlier than otherwise, leading to one of two costs:
They assume that excess capacity is free, since it is not being used currently and

cannot be sold off or rented, in most cases.
They allocate a portion of the book value of the plant or resource to the project.

Thus, if the plant has a book value of $ 100 million and the new project uses 40%
of it, $ 40 million will be allocated to the project.
We will argue that neither of these approaches considers the opportunity cost of using
excess capacity, since the opportunity cost comes usually comes from costs that the firm
will face in the future as a consequence of using up excess capacity today. By using up
excess capacity on a new project, the firm will run out of capacity sooner than it would if
it did not take the project. When it does run out of capacity, it has to take one of two
paths:
New capacity will have to be bought or built when capacity runs out, in which

case the opportunity cost will be the higher cost in present value terms of doing
this earlier rather than later.
Production will have to be cut back on one of the product lines, leading to a loss

in cash flows that would have been generated by the lost sales.
Again, this choice is not random, since the logical action to take is the one that leads to
the lower cost, in present value terms, for the firm. Thus, if it cheaper to lose sales rather
than build new capacity, the opportunity cost for the project being considered should be
based on the lost sales.
A general framework for pricing excess capacity for purposes of investment
analysis asks three questions:
(1) If the new project is not taken, when will the firm run out of capacity on the
equipment or space that is being evaluated?
(2) If the new project is taken, when will the firm run out of capacity on the equipment or
space that is being evaluated? Presumably, with the new project using up some of the
excess capacity, the firm will run out of capacity sooner than it would have otherwise.
(3) What will the firm do when it does run out of capacity? The firm has two choices:
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It can cut back on production of the less profitable product line and make less profits than
it would have without a capacity constraint. In this case, the opportunity cost is the
present value of the cash flows lost as a consequence.
It can buy or build new capacity, in which case the opportunity cost is the difference in
present value between investing earlier rather than later.

2. Product Cannibalization
Product cannibalization refers to the phenomenon whereby a new product
introduced by a firm competes with and reduces sales of the firm™s existing products. On
one level, it can be argued that this is a negative incremental effect of the new product,
and the lost cash flows or profits from the existing products should be treated as costs in
analyzing whether or not to introduce the product. Doing so introduces the possibility that
of the new product will be rejected, however. If this happens, and a competitor now
exploits the opening to introduce a product that fills the niche that the new product would
have and consequently erodes the sales of the firm™s existing products, the worst of all
scenarios is created “ the firm loses sales to a
Product Cannibalization: These are sales
competitor rather than to itself.
generated by one product, which come at the
Thus, the decision whether or not to
expense of other products manufactured by the
build in the lost sales created by product same firm.
cannibalization will depend on the potential for
a competitor to introduce a close substitute to the new product being considered. Two
extreme possibilities exist: the first is that close substitutes will be offered almost
instantaneously by competitors; the second is that substitutes cannot be offered.
If the business in which the firm operates is extremely competitive and there are no

barriers to entry, it can be assumed that the product cannibalization will occur
anyway, and the costs associated with it have no place in an incremental cash flow
analysis. For example, in considering whether to introduce a new brand of cereal, a
company like Kellogg™s can reasonably ignore the expected product cannibalization
that will occur because of the competitive nature of the cereal business and the ease
with which Post or General Food could introduce a close substitute. Similarly, it
would not make sense for Compaq to consider the product cannibalization that will
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occur as a consequence of introducing a Pentium notebook PC since it can be
reasonably assumed that a competitor, say IBM or Dell, would create the lost sales
anyway with their versions of the same product if Compaq does not introduce the
product.
If a competitor cannot introduce a substitute, because of legal restrictions such as

patents, for example, the cash flows lost as a consequence of product cannibalization
belong in the investment analysis, at least for the period of the patent protection. For
example, Glaxo, which owns the rights to Zantac, the top selling ulcer drug, should
consider the potential lost sales from introducing a new and maybe even better ulcer
drug in deciding whether and when to introduce it to the market.
In most cases, there will be some barriers to entry, ensuring that a competitor will either
introduce an imperfect substitute, leading to much smaller erosion in existing product
sales, or that a competitor will not introduce a substitute for some period of time, leading
to a much later erosion in existing product sales. In this case, an intermediate solution,
whereby some of the product cannibalization costs are considered, may be appropriate.
Note that brand name loyalty is one potential barrier to entry. Firms with stronger brand
name loyalty should therefore factor into their investment analysis more of the cost of
lost sales from existing products as a consequence of a new product introduction.


6.5. ˜: Product Cannibalization at Disney
In coming up with revenues on its proposed theme parks in Thailand, Disney estimates

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