- CFA Exams
- CFA Level I Exam
- Topic 3. Corporate Issuers
- Learning Module 5. Capital Investments and Capital Allocation
- Subject 3. Capital Allocation Principles and Pitfalls
CFA Practice Question
A company is considering building a distribution center on undeveloped land that it acquired more than ten years ago at a cost of $400,000. The company estimates the cost of putting in utilities, sewers, roads, and other such costs of preparing the land for the distribution center at $200,000. Alternatively, the undeveloped land could be sold today to another company for $600,000. In evaluating this capital project, the investment outlay associated with the use of the land by the distribution center will most likely be ______.
A. $400,000
B. $600,000
C. $800,000
Explanation: The investment outlay associated with the use of the land should reflect the opportunity cost of the foregone sale ($600,000) plus the incremental cost of preparing the land for use as a distribution center ($200,000). $600,000 plus $200,000 equals $800,000.
User Contributed Comments 6
| User | Comment |
|---|---|
| CJPerugini | The explanation is completely wrong. Investment outlay refers to the funds needed to complete a certain project. Opportunity cost is not factored in as it is the amount foregone. The answer should be the cost of the land plus the cost of preparing the land for its intended purpose. $600,000. |
| adidas | @CJPerugini: the answer is correct. It is the opportunity cost 600,000 + preparation cost 200,000 = 800,000. The original price of 400,000 should not even be considered as it is the sunk cost. Another way to think of this is how much is the 400,000 spent 10 years ago worth today? You cannot just say 400,000. |
| ascruggs92 | Another way to think about it: Say only the $200K is included in the investment outlay at the beginning and you get an NPV of $450K. Should you accept the project? No, because you'd be better off selling the land for $600K now. If you include the $600K in the initial investment outlay, it eliminates the need for comparison and allows you to accept/reject based on NPV being greater/less than zero |
| lty423 | good question!! |
| MattG | Two good explanations from @adidas and @ascruggs92. Thank you. |
| Naza34 | @adidas: you make a valid point, but land is recorded at historical cost and it's not depreciated, so you could still claim the cost is $400k. I didn't include the opportunity cost because they asked for an outlay, an actual disbursement of money, I don't even know what to think now. LOL |