Question

Tesco Industrial Co. is considering an expansion project. The necessary equipment could be purchased for $9,000,000 and the project would also require an initial $3,000,000 investment in net operating working capital. The company’s tax rate is 40%.

1. a) What is the initial investment outlay?
2. b) The company spent and expensed $50,000 on research related to the project last year. Would this

change your answer? Explain.

c) The company plans to house the project in a building it owns but is not now using. The building

could be sold for $1,000,000 after taxes and real estate commissions. How would this affect your answer?

Answer 1

a)Computation of Initial Cash Outflow:
Purchase of Equipment	$         9,000,000
Investment in Working Capital	$         3,000,000
Initial Cash Outlay	$      12,000,000

b) $ 50,000 spent on research last year is a sunk cost and is not a relevant cost for decision making. The amount is already spent, thus this would not change our answer.

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.

c) The cash inflows on sale of Building ($ 1,000,000) are dependent on acceptability of project, i.e., if the project is accepted Tesco Industrial Co. has to forego these cash inflows. Hence it is an opportunity cost and is relevant for decision making.

As these cashflows are relevant Initial Outlay will be increased by $ 1,000,000.

In this case, Initial Cash Outlay

Computation of Initial Cash Outflow:
Purchase of Equipment	$         9,000,000
Oppurtunity cost on (Sale of Buliding)	$         1,000,000
Investment in Working Capital	$         3,000,000
Initial Cash Outlay	$      13,000,000