Question

You own a 25 acre strawberry farm. You currently lease the land to a strawberry farmer for $14,000 per year. Your annual administrative (or fixed) costs from owning the farm are approximately $2,000 per year.

1. You could sell the land for $160,000 today and currently have an investment opportunity for the $160,000 from which you expect to make a return of 8% per year.

a.        What are your accounting profits for the year?

b.       What are your economic profits for the year?

c.       Should you sell the land today? Explain why.

2. Now, suppose that price of the land is expected to decrease from its current value of $160,000 to $155,000 next year. Should you lease the land for $14, 000 for one year and wait to sell the land at the end of the year for $155,000? Or should you forget leasing and just sell the land for $160,000 today at its current value? Explain why. (ignore the time value of money, for now).

Answer 1

Answer 1(a)

Accounting profits for the year = Lease income - annual administrative (or fixed) costs

= $14000 - $2,000

= $12,000

Accounting profits for the year = $12,000

Answer 1(b):

You could sell the land for $160,000 today and currently have an investment opportunity for the $160,000 from which you expect to make a return of 8% per year

Hence:

Opportunity cost =160000 * 8% = $12,800

Hence:

Economic profits for the year = 12000 -12800 = - $800

Answer 1(c):

Yes,

You should sell the land today.

Reason:

You are having negative economic profit of $800 since opportunity cost of land ($12,800 per year) is higher than the current accounting profit.

If you sell you will earn $12,800 per year which is higher by $800 per year as compared to current profit of $12,000

Answer 2:

You should forget leasing and just sell the land for $160,000 today at its current value

Reason:

Option1: Lease the land for $14, 000 for one year and wait to sell the land at the end of the year for $155,000.

In this case current year profit = $12,000

Future profit every year starting next year = 155000 * 8% = $12,400

Option2: Forget leasing and just sell the land for $160,000 today at its current value

Current year profit as well as future profit per year = $160,000 * 8% = $12,800

Option 2 has financial advantage as compared to option 1 since:

It gives additional profit of $800 in current year and stream of $400 as higher profit every year next year onward.