Question

Discuss how you understand the following concepts instrumental in capital budgeting decision making:

1.Opportunity cost

2.Cannibalization

3.Positive externalities

4.Sunk cost.

Note, providing just definitions would not satisfy requirements for this discussion. Initial response 250-300 words

Answer 1

OPPORTUNITY COST

Opportunity costs means the cost of next best alternative available to an enterprise. It represent the benefits that an individual or business misses out on when choosing one alternative and rejecting the other. Business owners can use it to make well informed decisions when they have multiple options before them.

Opportunity costs can be easily overlooked if one is not careful. Opportunity cost can be computed using the following formula -

Opportunity Cost = FO−CO

where: FO=Return on best foregone option

CO=Return on chosen option

CANNIBALIZATION :-

Market cannibalization refers to the loss in sales of comapny as a result of company's introduction of a new product that displaces one of its own older products. As a result of market cannibalization there is no increase in the company's market share but the sales for the new product increases. Market cannibalization occurs when a new product is similar to an existing product, and customer base for both of them is same.

Market cannibalization is often unintentional when the promotion of new product by a company reduces the sales of old product.

POSITIVE EXTERNALITIES

Positive externalities occurs when the consumption or production of a good causes a benefit to a third party. It lead to under-consumption and market failure. Government policies to increase demand for goods with positive externalities include With positive externalities, the benefit to society is greater than your personal benefit.

For example: Farmer who grows apple trees provides a benefit to a beekeeper. The beekeeper gets a good source of nectar to help make more honey. (positive production externality)

SUNK COST:

Sunk cost refers to the cost which has to be incurred under all altenatives and which can not be avoided. This is fixed cost which can not be avoided.

A sunk cost is a cost that has already been and cannot be recovered in any way. if your business is failing and your only option is to shut it down, you're cutting your losses. Saving money in the event of a sunk cost doesn't mean getting any of that money back, but it can mean avoiding losing additional money.

For example, Purchase of equipment is sunken costs to it when it's time to replace it with a newer model you may be able to sell some of the parts for money and you may be able to reuse other parts.

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