Explain why sunk costs should not be included in a capital budgeting analysis but opportunity costs...

Explain why sunk costs should not be included in a capital budgeting analysis but opportunity costs and externalities should be included (1 point). Give an example of each (1 point).

Expert Solution

Sunk costs are the amount of fund which has been already invested and it will have no effect on future cash flows. As capital budgeting analysis is dependent on future cash flows, sunk costs are not included. For eg, rent is a sunk cost. If a project uses a building and pays rent for it, it will not affect future cash flows as it has to be paid irrespective of the circumstances.

Opportunity costs should be included as it gives the return of the next best alternative; a capital budgeting analysis is done to know whether the project is beneficial for the firm and by how much. In order to know how much it is beneficial from other projects, a benchmark is needed and opportunity costs serve as the purpose of the benchmark. For eg, a project gives return of 10 % and if the money is deposited in bank, it gives 6 % as return. Hence, it aids in knowing that the project is more beneficial by 4 % in comparison to depositing money in the bank.

Externalities are included in capital budgeting analysis as it shows whether the project will have effect on another project or not, and how is the effect, whether positive or negative. For eg, a plant is being established to increase the sales of an existing product. Hence, it is essential to know whether the establishment of this plant will increase the sales or not and by how much.

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