Question

Opportunity cost.  Revolution Records will build a new recording studio on a vacant lot next to the operations center. The land was purchased five years ago for ​$490,000. ​ Today, the value of the land has appreciated to ​$800,000. Revolution Records did not consider the value of the land in its NPV calculations for the studio project​ (it had already spent the money to acquire the land long before this project was​ considered). The NPV of the recording studio is ​$560,000. Should Revolution Records have considered the land as part of the cash flow of the recording​ studio? If​ yes, what value should be​ used, ​$490,000 or ​$800,000​? How will the value affect the​ project?

Answer 1

The market value of land should be considered in NPV computation. Hence $800,000 should be used.

This is because the firm is losing the opportunity to sell the land and get the amount of $800,000 by undertaking this studio project. The value will reduce the NPV by 800,000 and the firm must also consider the value of the land at the end of the project. The NPV will increase by the present value of the future value of the land. Accordingly the project must be assessed.