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 Topic: investment ( Topic Closed)
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cpagoal2009
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Posts: 72
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| Posted: 15 Nov 2009 at 09:25 | IP Logged
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Can somebody explain me why the Current assets & liabilities r take in consideration for the investment.
Lawson Inc. is expanding its manufacturing plant, which requires an investment of $4 million in new equipment
and plant modifications. Lawson's sales are expected to increase by $3 million per year as a result of the
expansion. Cash investment in current assets averages 30 percent of sales; accounts payable and other current
liabilities are 10 percent of sales. What is the estimated total investment for this expansion?
a. $3.4 million.
b. $4.3 million.
c. $4.6 million.
d. $4.9 million.
Choice "c" is correct. $4.6 million estimated total investment for this expansion.
$4,000,000 Original investment
900,000 [(.30)(3,000,000)] expansion of current assets
(300,000) [(.10)(3,000,000)] expansion of current liabilities
$4,600,000 Total investment for expansion
Choices "a", "b", and "d" are incorrect, per the above calculation.
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bryris
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| Posted: 15 Nov 2009 at 09:56 | IP Logged
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When making an investment decision, only relevant costs are included. Relevant means anything that is going to change as result of the decision you are trying to make.
So, why does a company keep working capital to begin with? It is to serve as a buffer to absorb ebbs and flows of money. If you dealt with one customer to which you sold $10 of oranges per week, you might be inclined to keep about $3 in your reserve to handle things such as purchasing replacement oranges for ones that splat by accident or spoil, etc. OTOH, you may not get paid the $10 from the customer on time and will require some extra cash on hand to pay your supplier, etc.
If you are selling $1,000 a week in oranges, that $3 won't work anymore. You'll need more like $300 in order to absorb the problems you can face.
As such you need to pull that extra $297 bucks from an investment you have to put it into the bank to serve this purpose. Therefore, whatever interest you were earning on the $297 is now not being earned.
In this case, with the investment, obviously the 4,000,000 is to be spent on the machine. However, since sales are to increase, the volume (not percentage) of working capital required to be held has an opportunity cost to it. The 600,000 increase in working capital reflects this added investment.
Note that the question asks for the investment. If it had asked for the cost, you'd have to utilize the weighted cost of capital and calculate the actual cost of diverting that money to said purpose instead of investing it.
Does that make sense?
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