TeleStark is considering building a new manufacturing plant. This plant will cos

Question

TeleStark is considering building a new manufacturing plant. This plant will cost $9 million to build. The new plant will produce cash inflows of $2.05 million per year for the next 7 years. TeleStark already owns the land on which it intends to build the new plant. TeleStark spent $1.3 million to excavate the land and prepare it for development. Rather than building the plant, TeleStark could sell the land today for a net gain of $2 million. If TeleStark’s required return is 9.1%, should it build the plant? How much value does this project create (or destroy) in present value terms?

Explanation / Answer

Solution:

Gain from Sale of $ 2 million

If the plan is built, then cash inflows will be -

In both the situations the gain from sale of land is more than the returns in situations of purchase of plants, thus its better to sell the land.

If land development cost is not treated as sunk cost Cash Outlows ( in million ) Purchase cost of Plant 9.00 Land Development Cost 1.30 Total Investment 10.30 Inflows ( year 1 to 7 ) 2.05 Present Value Annuity of $ 1 @ 9.1% for 7 years 5.02 Present Value of Cash inflows 10.291 Net present value or Return = Present Value of Cashflows - Total Investment Return -0.01

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