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Any sunk costs associated with specific investment proposals by firms should not be included in NPV estimates of those projects. However, in certain instances, expected sunk costs associated with future investment proposals should be included in NPV estimates of current projects. If the future expected sunk costs, where appropriate, are not considered, there will be a bias toward rejecting the current investment proposals. This paper develops the appropriate decision rule for the inclusion or exclusion of future sunk costs.
INTRODUCTION
Corporate finance theory dictates that any sunk costs associated with a particular project should not be considered when estimating that project's net present value (NPV). This paper suggests that, in certain instances, sunk costs associated with future project proposals should be included in the NPV analysis of current project proposals. The failure to do so will result in NPV estimates that are systematically undervalued.
INCREMENTAL CASH FLOWS
Capital budgeting theory suggests that only the future incremental cash flows associated with a particular project should be included in that project's NPV analysis. In general, corporate finance texts suggest that the relevant cash flow components for a particular project could include any or all of the following: net operating cash flow, changes in net working capital, additional capital expenditures, salvage value, opportunity costs, option value, positive externalities or side effects related to synergy and negative externalities related to sales erosion for existing products (see, for example (Ross, Westerfield and Jordan, 2008), (Brealey and Myers, 2006), (Gitman, 2009), (Berk and DeMarzo 2011)). Sunk costs that already have been incurred should not be included in the NPV estimation because they are not part of the future incremental cash flow associated with the acceptance of the project.
While the concept of sunk costs may seem obvious, some interesting questions arise in practice. For instance, the timing of the NPV decision relative to the timing of any developmental project costs will affect the estimated NPV of the project. The later the NPV analysis is conducted, the greater is the portion of developmental costs that will be considered a sunk cost. If the NPV analysis is conducted earlier, more of the developmental costs will be included in the NPV analysis since they have not yet been incurred. The relevant point for...