Question

Referencing textbook readings, lecture material, and current business resources explain why sunk costs should not be included in a capital budgeting analysis but opportunity costs and externalities should be included. Give an example of each.

Also, explain why net operating working capital is included in a capital budgeting analysis and how it is recovered at the end of a project’s life.

Answer 1

Sunk cost represents the cost that is already incurred. The capital budgeting decision will make no difference to this particular cost since it is already paid and hence it is not included in capital budgeting analysis. For instance a company has already spend $15,000 on research as regards the installation of a new machinery. Since this amount is already spent the capital budgeting decision will not change if this cost is taken into consideration. For making capital budgeting decisions, the additional costs which will arise due to this decision are the ones to be taken into account.

Opportunity costs are included in capital budgeting decisions since they represent the cost of an alternative option available to the business. For instance instead of using an old equipment for another 10 years the business has an option of selling it immediately for $50,000. This represents an opportunity cost which would be foregone if the equipment is continued to be used. Externalities refer to the impact of external environment on the project. For instance change in exchange rate will change the amount of cash flows which should be considered in the capital budgeting decision making.

The net operating working capital should be included in the capital budgeting analysis because it represents a change in the cash flows of the business relevant to the capital budgeting decision. For instance there could be a need for greater inventory in case a new machine is required to be installed and this represents additional cash outflow for the business. At the end of the project this additional inventory would be released and converted to cash. Hence the working capital is recovered at the end of the project.