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 4 years ago for $4170000 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 $3549000. An engineer was hired to study the land at a cost of $728000, and her conclusion was that the land can support the new manufacturing facility. The company wants to build its new manufacturing plant on this land; the plant will cost $4334000 million to build, and the site requires $982000 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?

Answer 1

Cost of land is sunk cost (past cost) and should not be considered while evaluating the project. Similarly, amount paid for study of land to engineer is also a sunk cost since it already has been paid and will not affect the project.

Market value of land today is the opportunity cost of investing in the project. This benefit will be forgone if we choose to invest in the project. Therefore, the market value of land today should be added to initial investment.

Initial investment = Cost of plant + Cost of grading + market value of land today = $4,334,000 + $982,000 + $3,549,000 = $8,865,000