Question

1. You are considering investing in a new project, Project B. Your firm has already invested in one project, Project A. If the cash flows to Project A will increase when you invest in Project B, should you include the entire cash flows to Project A in your valuation of Project B, include the new cash flows to Project A in the valuation of Project B, or exclude any cash flows to Project A in the valuation of Project B? Explain your answer.

2. You have a project that has just ended, and you are trying to determine how best to use the plant/property/equipment that is no longer needed. The plant/property/equipment is fully depreciated. From a finance perspective, when deciding on whether or not you should sell the plant/property/equipment, is it important to consider what you paid for the plant/property/equipment? Why or why not?

Answer 1

1)

Sol: As given in the question, Project B is a new project and if the firm invests in Project B, the cash flows to Project A will increase. Thus, the incremental cash flows to Project A is only because of investment in Project B or we can say the incremental cash flows to Project A is the negative opportunity cost of Project B (i.e. Cash inflows to Project B).

Therefore, the firm should include the incremental cash flows to Project A in the valuation of Project B.

2)

Sol: As given in the question, the Plant/Property/Equipment is fully depreciated and is no longer needed and should therefore become a Sunk Cost (i.e. Historical Cost which has no relevance for decision making) for future.

Therefore, it is not important to consider the cost of such Plant/Property/Equipment (amount paid for such Plant/Property/Equipment) while deciding whether to sell it or not.