Shelton Co. purchased a parcel of land six years ago for $858,500. At that time, the firm invested $130,000 in grading the site so that it would be usable. Since the firm wasn't ready to use the site itself at that time, it decided to lease the land for $46,500 a year. The company is now considering building a warehouse on the site as the rental lease is expiring. The current value of the land is $910,000. What value should be included in the initial cost of the warehouse project for the use of this land

The current value of land = $910,000.

This should be included in the cost of warehouse project.

Explanation:

Before, answering this question, we need to understand few concepts:

Opportunity cost:

Opportunity costs represent the benefits an individual, investor or business misses out on when choosing one alternative over another. An opportunity cost is relevant to decision-making.

Sunk cost

A sunk cost refers to money that has already been spent and which cannot be recovered. Sunk costs are excluded from future business decisions because the cost will remain the same regardless of the outcome of a decision.

Relevant cost

Relevant costs and revenues are those costs and revenues that change as a direct result of a decision taken.

Relevant cost of non-current assets

The relevant costs associated with non-current assets, such as plant and machinery, are determined in a similar way to the relevant costs of materials.

Case 1:

If plant and machinery is to be replaced at the end of its useful life, then the relevant cost is the current replacement cost.

Case 2

If plant and machinery is not to be replaced, then the relevant cost is the higher of the sale proceeds (if sold) and the net cash inflows arising from the use of the asset (if not sold).

Solution:

We are under Case 1

The current value of land = $910,000.

This is the opportunity cost of the land in the warehouse project. If the project is not undertaken the land can be sold.  This should be included in the cost of warehouse project.

Cost of land = $858,500 which is sunk cost.

The cost of upgradation = $130,000

It is also a cost incurred in past, so it is a sunk cost.

The lease rental = $46,500. The lease amount is irrelevant since the lease is expiring.

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