Cash Flows and Land

¶ … Financial Calculations The Pickens Mining company has to make a decision with respect to whether or not it wants to develop a strip mine. Doing this is to fulfill a contract that it does not currently have. The decision needs to be based on careful analysis of the different cash flows, ensuring that only those incremental to this decision are included. In a capital budgeting situation, only the incremental cash flows are taken into account in the calculation (Investopedia, 2016).

One of the key issues that arises is with respect to opportunity cost. In this case, the company already owns the land, so going ahead with the project would mean that the land cannot be used for any other purpose. This is an interesting issue because the sunk cost associated with buying the land in the first place is excluded outright as not incremental. Selling the land, however, is just one possibility in a universe of possibilities -- this is not a binary decision.

That is where opportunity cost gets tricky in capital budgeting. A non-binary decision opens up multiple opportunity costs, none of which may be actually used. In this case, there is nothing to indicate that a binary decision exist. Pickens could theoretically sell the land for $7.4 M (it thinks) but if it was not planning to do so then this is not an incremental cost. The company can extract benefit from that land in many ways, and with many potential timeframes.

Deciding what to do with the land is a whole other decision -- it may prove to be a better number than using the land, an analysis that should be conducted. If this is a whole other decision, that means it is not incremental to this particular decision. With the equipment, only the first four years of depreciation is incremental to this decision, because the company intends to use the equipment for other projects following this one, rather than selling it.

What the company chooses to do with the equipment at that point in time -- it clearly has options -- is its own decision. We only know that the equipment will accrue a depreciation tax benefit for four years on this project, so that is all that can be included, though of course the 7-year MACRS rates would still apply. The decision to donate the land as a park is not incremental to the decision to develop the mine.

It is a subsequent decision, to be made on its own merits. The payback period is the simplest. The working capital will not be included in this, because theoretically the working capital will have to be returned. Also, it ends up being immaterial. The payback period is about 1.5 years, which is quite good. The second method is the profitability index. This is the present value of future cash flows divided by the initial investment.