Question

Kenny, Inc., is looking at setting up a new manufacturing plant in South Park. The company bought some land six years ago for $7.9 million in anticipation of using it as a warehouse and distribution site, but the company has since decided to rent facilities elsewhere. The land would net $10.7 million if it were sold today. The company now wants to build its new manufacturing plant on this land; the plant will cost $21.9 million to build, and the site requires $940,000 worth of grading before it is suitable for construction.
Required:
What is the proper cash flow amount to use as the initial investment in fixed assets when evaluating this project?

Answer 1

Answer:

$33,540,000

Explanation:

initial investment:

• opportunity cost of land (resale price of land) = $10,700,000
• building cost of the facilities = $21,900,000
• other expenses related to the site (grading) = $940,000
• total $33,540,000

The purchase cost of the land is considered a sunk costs, since it is not relevant now. What is relevant is the price at which the land could be sold at the moment of starting the project.