Bruce Moneybags owns several restaurants and hotels near a local interstate. One

Question

Bruce Moneybags owns several restaurants and hotels near a local interstate. One restaurant, Beef & More, needs to be modernized. Bruce is trying to decide whether to accept an offer to sell Beef & More as is for the offer price of $1.1 million or renovate the restaurant himself. The projected renovation cost is $1.3 million. The restaurant would need to be shut down completely during the renovation which would cause a net operating cash flow loss of $210,000 in today's dollars. The estimated present value of the cash inflows from the renovated restaurant are $3.2 million. When analyzing the renovation project, what opportunity cost, if any should be included for the current restaurant? Assume the restaurant is totally paid for and any future costs will be paid in cash.

A. there is no opportunity cost since the current restaurant is owned free and clear

B. the opportunity cost is the value of the current offer to buy the restaurant

C. the opportunity cost is the cost of the needed improvements

D. the opportunity cost is the present value of the loss of operating cash flows while the restaurant is closed for renovation

E. the opportunity cost is the cost of the renovations plus the loss of the operating cash flows during the renovation

Explanation / Answer

First of all we will evaluate whether the buy offer is good or not,

NPV of Rennovated Restaurant =$3.2 -1.3 =$1.90 million

This is higher than the price which is offered i.e. $1.10 million. So, selling the restaurant doesnt make sense.

We know that Opportunity Cost = Return of Most Lucrative Option - Return of Chosen Option

Thus, the ooportunity cost in our case will be the loss of Operating cash flows till which the restaurant remains closed and the cost of rennovations.

Thus, Option-E is the right answer.

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