Expansion versus replacement cash flows Edison Systems has estimated the cash fl

Question

Expansion versus replacement cash flows Edison Systems has estimated the cash

flows over the 5-year lives for two projects, A and B. These cash flows are summarized

in the table below.

Project A Project B

Project A Initial investment $40,000 and Project B Initial investment $12,000a

Year Operating cash inflows

Year 1 - Project A $10,000 and Project B $ 6,000

Year 2 - Project A 12,000 and Project B 6,000

Year 3 - Project A 14,000 and Project B 6,000

Year 4 - Project A 16,000 and Project B 6,000

Year 5 - Project A 10,000 and Project B 6,000

aAfter-tax cash inflow expected from liquidation.

a. If project A were actually a replacement for project B and the $12,000 initial investment

shown for project B were the after-tax cash inflow expected from liquidating

it, what would be the relevant cash flows for this replacement decision?

b. How can an expansion decision such as project A be viewed as a special form of

a replacement decision? Explain.

Explanation / Answer

a.

Project B is being replaced by project B. The after tax cah inflows from the liquidation of project B is $12000. Thus, the amount of cash inflow to be realised on the liquidation of project B will be deducted from the initial investment of Project A. The cash flows of the various years from project B is the opprotunity cost or the benefit foregone in undertaking project A and liquidating project B.

Relevant Cash flows for replacement decision would be:

Year 0 = 40000-12000 = 28000

Year 1 = 10000-6000 = 4000

Year 2 = 12000-6000 = 6000

Year 3 = 14000-6000 = 8000

Year 4 = 16000-6000 = 10000

Year 5 = 10000-6000 = 4000

b. Developing relevant cash flow estimates is most straight forward in the case of expnasion decision. In this case the inital incestment, operating cash flows and terminal cash flows are merely after tax cash inflows and outflows associated with the proposed capital expenditure. Actually, all capital budgeting decisions can be viewed as replacement decisions. Expansion decisions are merely replacement decisions in which all cash flows from the old asset are zero.

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