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 $5.8 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 $6.1 million. The company wants to build its new manufacturing plant on this land; the plant will cost $13.3 million to build, and the site requires $850,000 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

While evaluating the project we only consider the relevent cost. Relevent cost is the cost that will occur only due to the acceptance of the project.

In the given case the company has already bought the land 6years ago and hence it has no effect on acceptance or rejection of the project. Hence we will not cosider it in decision making because it is irrelevant.

However this land can be sold today and due to acceptance of the project the company will lose the profit that it can earn from sale of land. It is a oppurtunity cost and relevent in decision making hence we will consider it.

The cost of manufacturing plant and cost of grading is the relevent cost directly related to the project and hence we will consider it.

Now the given question has a line that "if the land were sold today, the company would net $1.6 million". There can be 2 interpretation of this line

1. The company would make net profit $6.1million from sale.

Hence the proper cash flow amount to use as initial investment in this case will be

Oppurtunity cost i.e ( profit that company would have earned if the project is not accepted) . = $6,100,000

Add. Manufacturing cost. = $13,300,000

Add. Grading cost. = $850,000

Total cost. = $20,250,000

Case 2- Assumption that the net sale proceed from land is $6.1million.

In this case we will first find out the profit i.e. (sale-cost) i.e. $(6.1-5.8) i.e. $0.3million.

Rest calculation will remain same and in this case the cost will come to $(0.3+13.3+0.85) i.e. $14,450,000

The sums language can be diffirent but not the concept. So focus on the concept, whatever is the case oppuropportcost will always be the profit that comapany is losing due to acceptance of the project.

I have solve this in both the alternatives, but i request you to focus on my writeups concept rather then solution for better understanding.

Thank you.

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