Ross et al.: Fundamentals
of Corporate Finance, Sixth
Edition, Alternate EditionIV. Capital Budgeting 10. Making Capital
Investment Decisions(^342) © The McGraw−Hill
Companies, 2002
INCREMENTAL CASH FLOWS
We are concerned here only with those cash flows that are incremental and that result
from a project. Looking back at our general definition, we might think it would be easy
enough to decide whether or not a cash flow is incremental. Even so, there are a few sit-
uations in which it is easy to make mistakes. In this section, we describe some of the
common pitfalls and how to avoid them.
Sunk Costs
Asunk cost, by definition, is a cost we have already paid or have already incurred the
liability to pay. Such a cost cannot be changed by the decision today to accept or reject
a project. Put another way, the firm will have to pay this cost no matter what. Based on
our general definition of incremental cash flow, such a cost is clearly not relevant to the
decision at hand. So, we will always be careful to exclude sunk costs from our analysis.
That a sunk cost is not relevant seems obvious given our discussion. Nonetheless, it’s
easy to fall prey to the fallacy that a sunk cost should be associated with a project. For
example, suppose General Milk Company hires a financial consultant to help evaluate
whether or not a line of chocolate milk should be launched. When the consultant turns
in the report, General Milk objects to the analysis because the consultant did not include
the hefty consulting fee as a cost of the chocolate milk project.
Who is correct? By now, we know that the consulting fee is a sunk cost, because the
consulting fee must be paid whether or not the chocolate milk line is actually launched
(this is an attractive feature of the consulting business).
Opportunity Costs
When we think of costs, we normally think of out-of-pocket costs, namely, those that
require us to actually spend some amount of cash. An opportunity costis slightly dif-
ferent; it requires us to give up a benefit. A common situation arises in which a firm al-
ready owns some of the assets a proposed project will be using. For example, we might
be thinking of converting an old rustic cotton mill we bought years ago for $100,000
into upmarket condominiums.
If we undertake this project, there will be no direct cash outflow associated with buy-
ing the old mill because we already own it. For purposes of evaluating the condo proj-
ect, should we then treat the mill as “free”? The answer is no. The mill is a valuable
resource used by the project. If we didn’t use it here, we could do something else with
it. Like what? The obvious answer is that, at a minimum, we could sell it. Using the mill
for the condo complex thus has an opportunity cost: we give up the valuable opportu-
nity to do something else with the mill.^1
There is another issue here. Once we agree that the use of the mill has an opportunity
cost, how much should we charge the condo project for this use? Given that we paid
$100,000, it might seem that we should charge this amount to the condo project. Is this
correct? The answer is no, and the reason is based on our discussion concerning sunk
costs.
The fact that we paid $100,000 some years ago is irrelevant. That cost is sunk. At a
minimum, the opportunity cost that we charge the project is what the mill would sell for
CHAPTER 10 Making Capital Investment Decisions 313
10.2
sunk cost
A cost that has already
been incurred and
cannot be removed and
therefore should not be
considered in an
investment decision.opportunity cost
The most valuable
alternative that is given
up if a particular
investment is
undertaken.(^1) Economists sometimes use the acronym TANSTAAFL, which is short for “There ain’t no such thing as a
free lunch,” to describe the fact that only very rarely is something truly free.