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 ​$400 comma 000400,000. ​ Today, the value of the land has appreciated to ​$800 comma 000800,000. 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 ​$570 comma 000570,000. Should Revolution Records have considered the land as part of the cash flow of the recording​ studio? If​ yes, what value should be​ used, ​$400 comma 000400,000 or ​$800 comma 000800,000​? How will the value affect the​ project?

Answer 1

NPV = Present value of cash inflows - present value of cash outflows

Since the land had already been purchased, it has not been considered in NPV calculation.

But one cannot ignore the fact that had the studio not been built, the land could have been sold for $800,000

The sale value of land is the opportunity cost and should be considered as a part of cash flow of the recording studio. The opportunity cost is $800,000. Hence, valuation used should be $800,000

Value of project will be $570,000 -$800,000

=-$230,000

Since the NPV is now negative, the studio should not be developed.