Question

* Answer the following questions. Your answer should include the relevant formula or equation and the final numbers. 1. Rowell Company spent $3 million two years ago to build a plant for a new product. It then decided not to go forward with the project, so the building is available for sale or for a new product. Rowell owns the building free and clear-there is no mortgage on it. Which of the following statements is correct? If the statement is not correct, explain why it is not. A) Since the building has been paid for, it can be used by another project with no additional cost. Therefore, it should not be reflected in the cash flows of the capital budgeting analysis for any new project. B) Since the building was built in the past, its cost is a sunk cost and thus need not be considered when new projects are being evaluated, even if it wouldſbe used by those new projects. C) This is an example of an externality, because the very existence of the building affects the cash flows for any new project that Rowell might consider. D) If the building could be sold, then the after-tax proceeds that would be generated by any such sale should be charged as a cost to any new project that would use it. E) If there is a mortgage loan on the building, then the interest on that loan would have to be charged to any new project that used the building.

Answer 1

A	Since the building has been paid for, it can be used by another project with no additional cost. Therefore, it should not be reflected in the cash flows of the capital budgeting analysis for any new project.	This is incorrect since the building is available for sale. Any sale proceeds that can be recovered from the sale of the building must be considered in the cash flows.
B	Since the building was built in the past, its cost is a sunk cost and thus need not be considered when new projects are being evaluated, even if it would be used by those new projects.	It will be true only if there is no salvage value.
C	This is an example of an externality, because the very existence of the building affects the cash flows for any new project that Rowell might consider	This is not correct due to the fact that it not an externality. The very existence of building does not affect the cash flow in any way. It was purchased years ago and has been paid off. There is no cash flow involved.
D	If the building could be sold, then the after-tax proceeds that would be generated by any such sale should be charged as a cost to any new project that would use it	This is CORRECT
E	If there is a mortgage loan on the building, then the interest on that loan would have to be charged to any new project that used the building	This is not correct because the loan was already taken before and the interest is a fixed cost. Even if the building would not have been in use the interest would still be paid on the mortgage.