Ames Manufacturing is considering the purchase of new, sophisticated machinery f

Question

Ames Manufacturing is considering the purchase of new, sophisticated machinery for a special three-year project. The machinery requires a special lubricating oil that probably will never be used, but must be available at all times should the machine break down. Ames purchases $2,000 of lubricating oil to keep on hand just in case it is needed. At the end of the three-year project, it is expected the lubricating oil can be sold back to the distributor for $2,000. Which of the following statements is most correct?
Answer a. The lubricating oil is a sunk cost that should be excluded from the analysis. b. The $2,000 for the lubricating oil should be excluded from the analysis because it is recovered at the end of three years, so the final cost is zero. c. The $2,000 represents an additional investment in working capital that should be included in the capital budgeting analysis. d. The $2,000 for lubricating oil is simply an accounting entry and does not represent a real cash flow.

Explanation / Answer

Option C is correct. First the investor has to invest $2,000 for the lubricates. Therefore it is treated as Working capital investment and we consider this in the capital budgeting analysis. It is not a Sunk cost. Sunk cost is already incurred that cannot be recovered regardless of whether the project is accepted or rejected.

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