Question

Parker & Stone, Inc., is looking at setting up a new manufacturing plant in South Park to produce garden tools. The company bought some land six years ago for $5.1 million in anticipation of using it as a warehouse and distribution site, but the company has since decided to rent these facilities from a competitor instead. If the land were sold today, the company would net $5.4 million. The company wants to build its new manufacturing plant on this land; the plant will cost $12.6 million to build, and the site requires $780,000 worth of grading before it is suitable for construction. What is the proper cash flow amount to use as the initial investment in fixed assets when evaluating this project? (Enter your answer as a positive value in dollars, not millions of dollars, e.g., 1,234,567.)

Answer 1

Solution:

As per the information given in the question we have

Cost of land bought by Parker & Stone Inc. six years ago at a cost = $ 5.1 Million.

This cost of land bought 6 years back, is a sunk cost and is not a relevant cash flow to be used in the calculation of initial investment in fixed assets.

The land bought six years ago, nets $ 5.4 Million if sold today.

This cost is an opportunity cost as the land could be sold at a certain price but is being used in the Project. This is a relevant cash flow to be used in the calculation of initial investment in fixed assets.

The company wants to build its new manufacturing plant on the land at a cost = $ 12.6 Million. This is a cash outflow required to initiate the project. Hence this is a relevant cash flow to be used in the calculation of initial investment in fixed assets.

The plant site grading cost = $ 780,000. This is a cash outflow required to initiate the project. Hence, this is a relevant cash flow to be used in the calculation of initial investment in fixed assets.

Based on the above information, the relevant cash flow to be used in the calculation of initial investment in fixed assets = Opportunity cost of land bought six years ago + Cost of new manufacturing plant + Plant site grading cost

= $ 5,400,000 + $ 12,600,000 + $ 780,000

= 18,780,000

Thus the proper cash flow amount to be used as the initial investment in fixed assets when evaluating the project = $ 18,780,000