Planning Capital Expenditure 299Sunk Costs
Sunk costs are expenses that have already been paid or have already been com-
mitted to. Past research and development are examples. Since sunk costs are
not incremental to the proposed project, NPV analysis must ignore them. NPV
analysis is always forward-looking. The past cannot be changed and so should
not enter into the choice of a future course of action. If research was under-
taken last year, the effects of that research might bear on future cash f lows,
but the cost of that research is already water under the bridge and so is not rel-
evant in the decision to continue the project. The project decision must be
made on the basis of whether the project increases or decreases wealth from
the present into the future. The past is irrelevant.
Overhead
The treatment of overhead often gives project managers a headache. Overhead
comprises expenditures made by the firm for resources that are shared by
many projects or departments. Heat and maintenance for common facilities are
examples. Management resources and shared support staff are other examples.
Overhead represents resources required for the firm to provide an environ-
ment in which projects can be undertaken. Different firms use different for-
mulas for charging overhead expenses to various projects and departments. If
overhead charges accurately ref lect the shared resources used by a project,
then they should be treated as incremental costs of operating the project. If
the project were not undertaken, those shared resources would benefit another
moneymaking project, or perhaps the firm could possibly cut some of the
shared overhead expenditures. Thus, to the extent that overhead does repre-
sent resources used by the project, it should be included in calculating incre-
mental cash f lows. If, on the other hand, overhead expense is unaffected by the
decision to undertake the new project, and no other proposed project could use
those shared resources, then overhead should be ignored in the NPV analysis.
Sometimes the formulas used to calculate overhead for budgeting purposes are
unrealistic and overcharge projects for their use of shared resources. If the fi-
nancial analyst does not correct this unrepresentative allocation of costs, some
worthwhile projects might incorrectly appear undesirable.
COMPUTING NPV: THE TIME VALUE OF MONEY
In deciding whether a project is worthwhile, one needs to know more than
whetherit will make money. One must also know whenit will make money.
Time is money! Project decisions involve cash f lows spread out over several pe-
riods. As we shall see, cash f lows in different periods are distinct products in
the financial marketplace—as different as apples and oranges. To make deci-
sions affecting many future periods, we must know how to convert the differ-
ent periods’ cash f lows into a common currency.