Question

6. Unlike replacement projects, expansion projects would most likely require

   1. the investor to be limited to straight-line depreciation methods only

   2. the owner to issue a combination of debt "and" equity instruments to raise capital

   3. a significant down-payment

   4. an increase in working capital

Answer 1

In replacement projects the project which is being replaced releases capital which can be used to finance the new one for example the sale of old project gives cashflows in form of sale of assets releasing of working capital these can be applied towards the new projects while in case of expansion projects there are no such funds available and that too the fund requirements in expansion projects are higher that those in replacement projects and it due capital market limitations and regulations entire fund can't be raised in form od equity that is why the owner has to use the mix of debt and equity one more reason to use this mix is that cost of equity is very high as compared to cost of debt so to minimise the overall cost of funds which is known as Weighted average cost of capital WACC owner uses an optimal mix as far as the depreciation is concerned then in case of replacement projects we are buying new assets to replace the existing ones which means they must be of same class or similar nature so depreciation method would also be similar for those assets while in case of expansion projects we are working with entirely new assets so we dont have exact idea as to which method should be used so we have to rely on SLM which is the most basic and comman method.