Parker & Stone, Inc., is looking at setting up a new manufacturing plant in Sout
ID: 2709526 • Letter: P
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 $4.1 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 $4.4 million. The company wants to build its new manufacturing plant on this land; the plant will cost $11.6 million to build, and the site requires $680,000 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?
Explanation / Answer
Current market value of land = $4.4 million. The land was purchased 6 years ago for use as warehouse and distribution site at a cost of $4.1 million.
For determining the inital investment in fixed assets for the plant, the current value of the land will have to be taken (as Parker and Stone would have had to buy land at this price for the plant, if the land was not already with it).
The amount spent on land will not be treated as sunk costs as this amount is not permanently lost. The company can recover money by selling the land. So the current market value will be included in the initial investment in fixed assets in reference to the project.
So, proper cash flow for the project = site grading costs+plant cost+current market value of land
= $680,000+11.6 million+4.4 million = $16.68 million. This is the amount of initial investment in fixed assets.