Question

Topic: Sunk Costs

a. If you have invested money into a project, but the remainder of the project has a negative npv, what should you do? should you continue the project? discuss your course of action relating to the topic stated above.

b. You have been given a project proposal. The project is expected to finish in five years (year 5) and has a cost of capital of 10%. If the initial costs of equipment is $400,000, the additional anticipated annual revenues for 5 years is $125,000, additional anticipated annual cash expenses for the first 2 years is $20,000. Assume taxes are not relevant.

Should you accept or reject the project? Please explain and compute/show work computing NPV by hand

Answer 1

(a): In this case you have already invested money into the project and hence the amount of your investment will be treated as a sunk cost. This is because this cost has already been incurred and cannot be recovered. As per capital budgeting norms this investment amount is now irrelevant when making the decision to continue with a project or not.

In this case you will compute the NPV of the project only by taking into consideration the relevant cash flows i.e. revenues and relevant costs. If the NPV is negative when relevant cash flows are considered then you should not go ahead with the project. On the other hand if the NPV is positive when relevant cash flows are considered then you should go ahead with the project.

(b): Here the investment of $400,000 has not been made and so this will not be a sunk cost but will be a relevant cost. Here we will compute the project’s NPV.

Present value of revenues = 125,000/1.1 + 125,000/1.1^2 + 125,000/1.1^3 + 125,000/1.1^4 + 125,000/1.1^5

= $473,848.35

Present value of expenses = -400,000 – 20,000/1.1 – 20,000/1.1^2

= -$434,710.74

NPV = present value of revenues + present value of expenses

= $473,848.35 -$434,710.74

= $39,137.60

As NPV is positive the project should be accepted.