Question

Nelson Mfg. owns a manufacturing facility that is currently sitting idle and is debt-free. The facility is located on a piece of land that originally cost $159,000. The facility itself cost $1,390,000 to build. As of now, the book value of the land and the facility are $159,000 and $458,000, respectively. The firm received a bid of $1,700,000 for the land and facility last week. The firm's management rejected this bid even though they were told that it is a reasonable offer in today's market. If the firm was to consider using this land and facility in a new project, what cost, if any, should it include in the project analysis

Answer 1

Answer:

The total cost to include in any project analysis should be $1,700,000, which can be apportioned as follows:

Land = $159,000/$617,000 * $1,700,000 = $438,088

Facility = $458,000/$617,000 * $1,700,000 = $1,261,912

Explanation:

The fair market values of the Land and Facility are $438,088 and $1,261,912, being the amounts at which the land and facility could be sold together to obtain $1,700,000.

In project analysis, the relevant cost to include is not the sunk cost of $617,000 ($159,000 and $458,000), but the opportunity cost.

$1,700,000 represents the opportunity cost.

The opportunity cost is the cost that would have been incurred assuming that the land and facility were sold at the first bid.  This represents the bid price for the land and facility.