Suppose a firm has a warehouse that they originally purchased for $500,000. They

Question

Suppose a firm has a warehouse that they originally purchased for $500,000. They have a project that they determine would be acceptable if the costs for the warehouse were at most $1,500,000. The firm has determined the market price for the warehouse is $2,000,000. Should the firm proceed with the project? Why or why not—what should the firm do with the warehouse?

Suppose that in the above case the firm originally purchased the warehouse for $2,500,000.
Would that change your answer? Would your answer change if the market price was only
$1,000,000? Explain how your answer would change

Explanation / Answer

1. The original cost of the warehouse is $500,000. This cost is historical or sunk cost and will not be relevant for future decision making.

The firm should evaluate the future economic benefits from the project, to determine whether the costs of running the project are justifiable. Since the project will be viable if the cost of warehouse is $1,500,000 it indicates that the break even point of the project is $1,500,000 (gross revenue excluding cost of warehouse). The firm can sell the warehouse for $2,000,000 since this is the market price. The firm can proceed with the project if it recovers this opportunity cost of not selling the warehouse ($2,000,000).

Thus, the firm should sell the warehouse, since the future economic benefits from the project ($1,500,000) are much lesser than the current market price of the warehouse.

2. The original cost of warehouse would be irrelevant for future decision making, since this is sunk cost already incurred. Therefore, even if the original cost was $2,500,000 the answer would not change.

3. If the market price was $1,000,000, the firm will have to evaluate the warehouse costs for executing the project. The gross revenue from the project is $1,500,000; if the costs of executing the project are less than $500,000, the firm should execute the project, since it will derive future economic benefits greater than $1,000,000 which is the current market price. Assuming that the warehouse costs for executing the project are less than $500,000, the company should execute the project.

(Note: Discounting has been ignored since the question is silent on the same)  

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