You Are Considering a New Project That Will Require an Initial

question 131

Multiple Choice

You are considering a new project that will require an initial buildup of raw materials inventory. The expected life of the project's equipment is seven years. If all goes as you expect, you will replace the equipment at the end of the seven years. If not, you will terminate the project. You currently believe there is a 50-50 chance of either occurrence. How should you treat the raw material inventory in year seven of your present analysis and why?

• A) Treat half of it as a cash inflow because there is a 50% chance the project will terminate then.
• B) Treat it as a cash outflow because it is expected that the machines will be replaced.
• C) Treat it as a cash inflow because the replacement of the machines becomes a new capital budgeting decision at that point.
• D) Treat it as both a cash inflow and outflow, net effect zero.
• E) Treat half as a cash inflow in year seven, but also treat only half as a cash outflow at the beginning of the project.

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Definitions:

Maximize Profits

A strategy or objective of firms to achieve the highest possible financial gain by optimizing production and sales, while minimizing costs.

Long-Run Cost Function

Describes the minimum cost at which a firm can produce any given level of output when all inputs, including capital, are variable.

Positive Output

The result of production processes that lead to an increase in the quantity of goods or services produced.

Long-Run Total Cost

The cumulative expense incurred by a firm when all inputs are variable, intended to capture the idea of planning and adjustment in the face of changing economic landscapes.