Question

Which of the following statements is CORRECT?

a.   A sunk cost is any cost that must be expended in order to complete a project and bring it into operation.

b.   A sunk cost is a cost that was incurred and expensed in the past and cannot be recovered regardless of whether the project is accepted or rejected.

c.   A sunk cost is any cost that was expended in the past but can be recovered if the firm decides not to go forward with the project.

d.   Sunk costs were formerly hard to deal with, but once the NPV method came into wide use, it became possible to simply include sunk costs in the cash flows and then calculate the PV.

A company is considering a proposed new plant that would increase productive capacity. Which of the following statements is CORRECT?

a.   In calculating the project's operating cash flows, the firm should notdeduct financing costs such as interest expense, because financing costs are accounted for by discounting at the WACC. If interest were deducted when estimating cash flows, this would, in effect, “double count” it.

b.   Since depreciation is a non-cash expense, the firm does not need to deal with depreciation when calculating the operating cash flows.

c.   When estimating the project’s operating cash flows, it is important to include both opportunity costs and sunk costs, but the firm should ignore the cash flow effects of externalities since they are accounted for in the discounting process.

d.   Capital budgeting decisions should be based on before-taxcash flows.

Clemson Software is considering a new project whose data are shown below.  The required equipment has a 3-year tax life, after which it will be worthless, and it will be depreciated by the straight-line method over 3 years. Revenues and other operating costs are expected to be constant over the project's 3-year life.  What is the project's Year 1 cash flow? Show work.

Equipment cost (depreciable basis)                            $80,000

Straight-line depreciation rate                                    33.333%

Sales revenues, each year                                           $70,000

Operating costs (excl. deprec.)                                   $40,000

Tax rate                                                                            35%

a.   $29,916.66                        b. $28.666.56              c. $27,575.55              d. $28,833.24  

Answer 1

1. Option c is correct A sunk cost is any cost that was expended in the past but can be recovered if the firm decides not to go forward with the project. Beacuse sunk costs are inccurred to decide or investigate whetjher a project is feasible or not. E.g Consultancy fees, Research expenses,etc.
2. Option a is correct. In calculating the project's operating cash flows, the firm should notdeduct financing costs such as interest expense, because financing costs are accounted for by discounting at the WACC. If interest were deducted when estimating cash flows, this would, in effect, “double count” it.
This is beacuse operating cash flows is EBIT which is calculated before deducting interest expense and only interest tax sgield is used for calculation and not interest.

3. Depreciation = 33.33% * 80,000 = 26,666.4
Projected cash flow = Sales - Operational cost - Depreciation - Taxes + Depreciation =
70,000 - 40000 - 26666.4- (70,000 - 40000 - 26666.4)*35% + 26,666.4 = 28833.24

Best of Luck. God Bless