You are contemplating on building a housing project. The land costs 4.5 million and the construction of a townhouse will cost 15.5 million. You can sell the entire project in a year’s time for 23 million. Assuming an opportunity cost of capital of 6% will you invest in the project? Why?
Answers
Answer:
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Concept:
One of the fundamental ideas in the study of economics, opportunity cost permeates many different types of decision-making processes. The value of the next best choice passed up is the opportunity cost. In simpler terms, it is the expense of an alternative course of action.
There are opportunity costs when there are options. If there seems to be only one choice available during the decision-making process, the default choice is to take no action, which has a cost of nothing. The opportunity cost of Decision A is the net benefit of Decision B, and vice versa, if a decision-maker must choose between Decision A and B.
Consider the scenario where a company finds oil on one of its properties. According to a land surveyor, the land can be sold for $40 billion. If the company is ready to invest $30 billion today, a consultant estimates that extracting the oil will result in operating revenues of $80 billion in present value terms.
The investment of $30 billion would yield an expected return of $80 billion, generating an accounting profit of $50 billion. The opportunity cost of not selling the land would be $40 billion, so choosing to extract would result in a $10 billion economic gain.
Given:
Cost of the land = 4.5 million
Construction of townhouse costs = 15.5 million
Sale value of entire project in a year's time = 23 million
Opportunity cost of capital = 6%
Find:
We have to find If you would invest in the project and why?
Solution:
Fixed Cost = 4.5+15.5 = 20 million
Total Cost = Fixed cost + Opportunity cost = 20+(20*6%) = 20+1.2 = 21.2 million
Profit = Sale value - Total cost = 23-21.2 = 1.8 million.
Since the Project is profitable of 1.8 million per year . I would like to invest in it.
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