Sunk Costs vs Opportunity Costs

In capital budgeting analysis, sunk costs are costs which are already incurred and which need not be reflected in the incremental cash flows used for estimation of net present value and internal rate of return. Sunk costs are named so because they can’t be recovered.

Opportunity costs on the other hand are costs which do not necessarily involve any cash outflows but which need to be considered because they reflect the foregone profit that could have been elsewhere. Opportunity costs are named so because they reflect the lost opportunity to earn profit form alternative use of the funds allocated to the project under consideration.

Capital budgeting decisions are based on current and future incremental cash flows and not any past cash flows. Therefore, in calculating net initial investment outlay, analysts need to ignore the sunk costs but include opportunity costs in their analysis.

Example

Green Metro, Inc. is a company interested in public transportation projects in developing countries. The company recently completed a traffic modelling study of a South Asian city at a cost of $5 million, which unveiled some attractive investment areas for the company to consider.

One option is to invest in a dedicated bus corridor along the main artery of the city. It requires initial investment of $270 million and would result in net cash flows of $20 million for next 20 years.

The company is also a supplier of sophisticated e-ticketing equipment to other transport companies, which cost $20 million per dedicated bus corridor and is sold at $30 million.

Following is the calculation of net initial investment outlay:

Identify any errors in the above calculation.

Solution

Two adjustments need to be made to the calculation of net investment outlay.

1. The e-ticketing equipment cost should be included at its sale price of $30 million instead of its cost of $20 million. This is because though the company will spend $20 million on in-house production of the system, it could sell this system at $30 million earning a profit of $10 million. Using an e-ticketing system in its own project would result in $10 million less profit elsewhere so this $10 million should be reflected in the net initial investment.
2. Traffic modelling study cost should not be included in the net investment outlay because it is a sunk cost. The study was conducted before taking any investment decision and it doesn’t affect any future cash flows of the project.

by Obaidullah Jan, ACA, CFA and last modified on Jan 4, 2016