In an otherwise unchanged subdivision residual model, entrepreneurial incentive is a separate deduction from projected net sales proceeds. If that deduction increases and it is not already counted in the discount rate or another cost, what happens to indicated raw-land value?
Correct Answer
D) It falls, since more is deducted from gross sales
With sales, other costs and timing unchanged, increasing a separately deducted entrepreneurial incentive reduces the residual available for land. Model the required return consistently: do not deduct the same risk/return allowance again if already captured elsewhere in the cash flow or rate.
Why This Is the Correct Answer
Option D is correct because entrepreneurial incentive is deducted from projected sales along with other costs, and land value is what remains. Increasing that deduction, with sales, other costs and timing unchanged, leaves a smaller residual, so indicated raw-land value falls.
Why the Other Options Are Wrong
Option A: It rises, since profit is added to the residual
Option A says land value rises because profit is added to the residual. Entrepreneurial incentive is a deduction in the model, not an addition, so a larger incentive lowers the residual.
Option B: It is unaffected, as profit is not a deduction
Option B says land value is unaffected because profit is not a deduction. In the subdivision model, entrepreneurial incentive is deducted with direct and indirect costs, so changing it changes the residual.
Option C: It rises in proportion to the profit percentage
Option C says land value rises in proportion to the profit percentage. A higher incentive increases the amount deducted, which reduces rather than increases the residual land value.
More taken, less left
Any increase in a deduction in a residual model shrinks the leftover amount that belongs to the land.
How to use: Use this to predict the direction of change in any residual calculation.
Exam Tip
For direction-of-change questions, ask whether the item is subtracted or added in the model before choosing.
Common Mistakes to Avoid
- -Treating developer profit as an addition to land value
- -Ignoring entrepreneurial incentive as a deduction
- -Counting the same return in both the incentive and the discount rate
Concept Deep Dive
Analysis
This question tests how deductions in a subdivision residual model affect land value. Land is the residual after all costs and entrepreneurial incentive are subtracted. If the incentive deduction grows while everything else stays the same, less remains for the land.
Background Knowledge
In the subdivision development method, direct costs, indirect costs and entrepreneurial incentive are deducted from gross lot sales, and the net proceeds are discounted to indicate raw land value. The required return should be modeled once, either as a separate incentive or within the discount rate, not both.
Real-World Application
An appraiser reviewing a developer's land purchase model notices the developer raised its required profit because of rising risk. With lot prices and costs unchanged, the appraiser explains that the developer can justify paying less for the raw land.
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