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 12 years ago for $6 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 $9.8 million. The company wants to build its new manufacturing plant on this land; the plant will cost $13.2 million to build, and the site requires $1,372,000 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?

Answer 1

Project Evaluation
Computation of Initial Cash Outflows
Particulars	Amount
Sale Value of Land (Opportunity Cost)	$       9,800,000
Grading of Site	$       1,372,000
Cost of New Manufacturing Plant	$     13,200,000
Initial Cash Outflows for investment	$ 24,372,000
in fixed assets

Cost of land ($ 6 Million) which is already incurred is a Sunk Cost and is not relevant for decision making.

The cash inflows on sale of land($ 9.8 Million) are dependent on acceptability of project, i.e., if the project is accepted Parker & Stone Inc., has to forego these cash inflows. Hence it is an opportunity cast and s relevant for decision making.

Cash outflows on account of Grading the site and Construction of plant are incremental on account of acceptance of project, they are relevant for decision making.

Note: A relevant cost is a cost that differs between alternatives being considered. In order for a cost to be a relevant cost it must be incurred in future Future which should require Cash Flow and is Incremental to present cash flows.

It is important to distinguish between relevant and irrelevant costs when analyzing alternatives because erroneously considering irrelevant costs can lead to unsound business decisions.

Sunk Costs are not relevant for decision making.