Question

Tannen Industries is considering an expansion. The necessary equipment would be purchased for $14 million, and the expansion would require an additional $4 million investment in net operating working capital. The tax rate is 40%.

A. What is the initial investment outlay? Round your answer to the nearest dollar. Write out your answer completely. For example, 13 million should be entered as 13,000,000.

B. The company spent and expensed $15,000 on research related to the project last year. Would this change your answer? Why?

I. No, last year's expenditure is considered a sunk cost and does not represent an incremental cash flow. Hence, it should not be included in the analysis.

II. Yes, the cost of research is an incremental cash flow and should be included in the analysis.

III. Yes, but only the tax effect of the research expenses should be included in the analysis.

IV. No, last year's expenditure should be treated as a terminal cash flow and dealt with at the end of the project's life. Hence, it should not be included in the initial investment outlay.

V. No, last year's expenditure is considered as an opportunity cost and does not represent an incremental cash flow. Hence, it should not be included in the analysis.

C. The company plans to use a building that it owns to house the project. The building could be sold for $5 million after taxes and real estate commissions. How would that fact affect your answer?

I. The potential sale of the building represents an opportunity cost of conducting the project in that building. Therefore, the possible proceeds after taxes and commissions must be charged against the project as a cost.

II. The potential sale of the building represents an opportunity cost of conducting the project in that building. Therefore, the possible proceeds before taxes and commissions must be charged against the project as a cost.

III. The potential sale of the building represents an externality and therefore should not be charged against the project.

IV. The potential sale of the building represents a real option and therefore should be charged against the project.

V. The potential sale of the building represents a real option and therefore should not be charged against the project.

Answer 1

Answer A:

Initial investment outlay = $18,000,000

Workings:

Initial investment outlay = Purchase cost of equipment + additional net operating working capital

= $14,000,000 + $4,000,000 = $18,000,000

Answer B:

The company spent and expensed $15,000 on research related to the project last year. Would this change your answer?

Correct answer is:

I. No, last year's expenditure is considered a sunk cost and does not represent an incremental cash flow. Hence, it should not be included in the analysis.

Explanation:

The expenditure of $15,000 on research related to the project last year has already been incurred and is sunk cost. Irrespective whether the company decides to go for the project or not to go for the project, this amount is already incurred and irrelevant for analysis evaluating the project.

Option II i incorrect as it is already incurred and not an incremental cash flow.

Option III is incorrect. Neither the cost nor its tax effect, if any, should be included in analysis.

Option IV and V are incorrect. The cost is already incurred and is a sunk cost.

Answer C:

The company plans to use a building that it owns to house the project. The building could be sold for $5 million after taxes and real estate commissions.

Correct answer is:

I. The potential sale of the building represents an opportunity cost of conducting the project in that building. Therefore, the possible proceeds after taxes and commissions must be charged against the project as a cost.

Explanation:

As the building can be sold, opportunity cost need to be charged to the project for use of building to house the project. The finacial evaluation of the project needs to factor in possible sale proceeds (after taxes and commissions).

Option II is incorrect. The opportunity cost is possible sale proceeds after taxes and commissions not "before taxes and commission"

Option III is incorrect.

Potential sale of the building is not an externality, it is integrated part of project as the plan is to use the building to house the project. The project need to factor in the opportunity cost of it.

Option IV: Compared to Option I, option IV is inappropriate. The context more relates to opportunity cost than real options.

Option V is incorrect. It is opportunity cost and is chargeable. The context more relates to opportunity cost than real options.