Any financial gurus out there? Help with HW question.?

Question

ABC Inc. is a firm that is considering developing a new product. In evaluating whether to go ahead with the new new project, which of the following statements is most correct?

a. The company will produce the product in a building that they already own. The cost of the building is therefore zero should be excluded from the analysis.

b. The company will need to use some equipment that could have been leased to another company. This equipment lease could have generated $100,000 per year in after-tax income. The $100,000 should be excluded because the equipment can no longer be leased.

c. The company will need to hire 8 new workers whose salaries and benefits will total $300,000 per year. Labor costs are not part of capital budgeting and should be excluded.

d. The company will produce the product in a building that it renovated two years ago for $200,000. The $200,000 should be excluded from the analysis

Answer 1

a. The company will produce the product in a building that they already own. The cost of the building is therefore zero should be excluded from the analysis.

The cost of the building is not zero. You have to factor in what it could have got you if you had leased out the building. And whether this potential rental income is higher than your potential rental expense if you were to move out and rent a building elsewhere.

b. The company will need to use some equipment that could have been leased to another company. This equipment lease could have generated $100,000 per year in after-tax income. The $100,000 should be excluded because the equipment can no longer be leased.

Same as above, you have to factor in the $100,000 income which you have missed out on by not leasing the equipment out.

c. The company will need to hire 8 new workers whose salaries and benefits will total $300,000 per year. Labor costs are not part of capital budgeting and should be excluded.

If you're trying to evaluate whether to proceed with a new project you have to take everything into consideration, not just capital expenditure. You do have to take into account this $300k in your calculations.

d. The company will produce the product in a building that it renovated two years ago for $200,000. The $200,000 should be excluded from the analysis

I presume that you have been operating out of this building all along and will continue to do so if you proceed with the new project. In that case, I would agree that the $200k has nothing to do with this current analysis.

So the answer is (d)