Capital Budgeting Sunk Costs Are Costs That

Capital Budgeting Sunk costs are costs that have already been incurred. So for example if a company spent money on a marketing assessment for a new product, that would not be included in the decision to bring that product to market because that money was already spent. Sunk costs are not included in a capital budgeting analysis. Opportunity costs are not included in a capital budgeting analysis. An opportunity cost is something that another opportunity that could have been taken up with that money.

Each opportunity should get its own analysis. Consider that there are, if one were to take this idea out to its logical conclusion, nearly endless opportunities. Clearly, the NPV of umpteen opportunities will outweigh the NPV of one, rendering every project a money-loser. The way to compare different options is to give each one its own capital budgeting analysis, and then choose the best one. Side effects. Side effects are things that occur in the aftermath of initiating the new project.

An example might be if a project increases capacity at one plant, that another plant elsewhere loses production, and costs more. The problem with side effects is that they rely on other decisions to be made (or not made). If the other plant wants to maintain its volumes, that is something for local sales reps to deal with, or for the plant managers there to find another product to make.

Ultimately the issue of side effects is usually raised in the context of negative side effects, but those might only occur if management does nothing about those situations. It has to be assumed that those are separate decisions, and that other decisions could be taken. Side effects that are in any way preventable should not be included in the calculation. This goes for positive side effects as well.

In the course of a capital budgeting analysis, it should be ensure that the project's champions do not include side effects that could be the result of a different decision. Changes in net working capital are a cash flow that needs to be taken into consideration. The reason for this is that when this working capital declines and is returned to the company, it will be at a point in the future. Thus, there is a difference in the present value of the changes in working capital.

Including them in the calculation accounts for the time value of money in respect of the changes in net working capital. Financing costs are not to be included in the calculation. Basically, financing costs are already built into the discount rate, which normally reflects the firm's weighted average cost of capital.

The financing costs of the entire firm are used, rather than the costs strictly associated with this project, in large part because of the Modigliani-Miller Theorem that holds the type of financing does not matter, all other things being equal. The capital structure decision, therefore, is a different decision entirely from the decision whether or not to undertake a project. There is some debate about whether or not taxes should be included.

The prevailing tax rate faced by the firm is not an incremental cash flow, per se, given how many other factors go into the tax rate. However, net cash flows are often used in the calculation, since that is the change in wealth that the company earns. That said, there is a certain amount of redundancy to using taxes, since the same rate is applied to each future flow. A positive flow will still be a positive flow, albeit smaller, if taxes are included; a negative flow.