case study of accounting
necolas00073
ExamplesonOpportunityCostandSunkCost.pptxOpportunity Costs
The opportunity cost of using a resource is the value it could have provided in its best alternative use.
E.g. suppose a firm bought a production line which will be placed in a warehouse that the company could have otherwise rented out for $20,000 per year.
Should you include this opportunity cost when calculating free cash flow?
Example
1
See notes underneath the slide
Q: Should you include this opportunity cost when calculating free cash flow?
A: Yes, because the firm forgoes $20,000 when choosing to place the production line in the warehouse instead of having it rented out.
The opportunity cost would reduce the firm’s incremental sales annually by the amount of $20,000
e.g. if incremental sales =$5,000, then the firm is better off by having the warehouse rented out.
The opportunity cost would reduce the firm’s incremental cash flows annually by this amount:
$20,000× (1 − Tax Rate)
1
Opportunity Costs
If don’t take the project, just rent out the warehouse
If take the project, but exclude the opportunity cost when calculating FCFs. Prone to make wrong decisions.
Tend to accept this project, but it is a WRONG decision.
2
Years
EBIT
0
1
2
3
4
0
20K
20K
20K
20K
Years
EBIT
0
1
2
3
4
-4K
5K
5K
5K
5K
How to Account for Opportunity Costs
Should include the opportunity cost when evaluating the project
Because the firm forgoes $20,000 when choosing to place the production line in the warehouse instead of having it rented out.
How? deduct the opportunity cost from the incremental sales
Conclusion from the above timeline: Don’t take the project. Right decision.
3
Years
EBIT
0
1
2
3
4
-4K
5K−20K
5K −20K
5K −20K
5K −20K
Sunk Costs
Sunk costs are costs that have been or will be paid regardless of the decision whether or not the investment is undertaken.
Sunk costs should NOT be included in the incremental earnings analysis.
Past Research and Development Expenditures
Money that has already been spent on R&D is a sunk cost and therefore irrelevant. The decision to continue or abandon a project should be based only on the incremental costs and benefits of the product going forward.
Timeline helps
4
See notes underneath the slide
For example, suppose after having spent $10,000 on market research, you believe 100% that your new product will generate an NPV of $100 (e.g., PV(benefits)=5,100, PV(costs)=5,000)
Note this already spent market research expense is NOT in the calculation of NPV (or PV(costs)) of the project you haven’t undertaken.
Does the market research expense of $10,000 you have already spent affect your decision of the new project?
No. That is a sunk cost.
Should you take the project?
Yes, because the NPV is positive.
What if the NPV of the project is just $1? Again this already spent market research expense is NOT in the calculation of NPV of the project. Should you take the project?
Yes, because the NPV is positive, so PV(benefits) > PV(costs). Note all the costs for this project have been taken out.
4
Sunk Costs
Firm spent 10K in Year -1 (last year). Suppose+ + =5K. Should you take the project?
Yes. Because if you do the project, you can still get a PV of 5K. If you don’t do the project, you will get nothing. Note the timing: you make the decision today, not at Year -1.
10K is a sunk cost. Should exclude sunk cost when making capital budgeting decisions.
5
Years
Cash flow
-1
0 (Today)
1
2
-10K
