Question

Conference Services Inc. has leased a large office building for $4 million per year. The building is larger than the company needs: two of the building's eight stories are almost empty. A manager wants to expand one of her projects, but this will require using one of the empty floors. In calculating the net present vlaue of the proposed expansion, upper management allocates one-eighth of $4 million of building rental costs (i.e., $.5 million) to the project expansion, reasoning that the project will use one-eighth of the building's capacity.

Is this a reasonable procedure for purposes of calculating NPV?

Circle one: Yes or No

If you circled yes, briefly explain why this is reasonable below. If you circled no, offer up a better way to assess a cost of the office spaced used by the project.

Answer 1

Answer: No

As the building Rent is an irrelevant cost as it is already being paid irrespective of acceptability of project

While assesing NPV of a project only relevant costs has to be Considered. A relevant cost is a cost that differs between alternatives being considered. In order for a cost to be a relevant cost it must be incurresd in Future, should result in Cash Flow and it should be Incremental to present Cash Flows.

It is important for Manager to distinguish between relevant and irrelevant costs when analyzing a proposed project because erroneously considering irrelevant costs can lead to unsound business decisions. Also, ignoring irrelevant data in analysis can save time and effort.

If the addition of Building rental which is not incrementally incurred for this project turns NPV to negative, it results in sub optimal decision of rejecting the project.

A better way to assess a cost of the office spaced used by the project is any revenue forgone(i.e., Oppurtunity Cost) due usage of office space for this project and any Incremental additional Cost incurred.