Discussion | Business & Finance homework help

1. Discuss why sunk costs should not be included in a capital budgeting analysis but opportunity costs and externalities should be included.

In capital budgeting, it can be essential to focus on relevant cash flows. Those can be affected by the investment decision process. Sunk costs, opportunity costs, and externalities are treated differently in this analysis:

• Sunk Costs: These are costs that have already been incurred and cannot be recovered. Since sunk costs do not change regardless of whether a project is accepted or rejected, they can be excluded from the analysis. Including sunk costs can lead to poor decision-making by overestimating the project's overall cost (Brigham & Ehrhardt, 2020). For example, money already spent on research for a project is irrelevant to the decision to proceed or not as it has already been expended.
• Opportunity Costs: These represent the benefits a company chooses by selecting one project over another. Unlike sunk costs, opportunity costs should be included in the analysis because they reflect the value of resources. If a firm owns land that could be sold for $1 million, and it plans to use that land to build a new factory. The $1 million should be considered an opportunity cost.
• Externalities: These are the side effects of a project which could be either positive or negative. The affect other parts of the company or external stakeholders. A project that reduces pollution could improve the firm’s public image, leading to higher sales. On the other side, a project that causes environmental damage might lead to fines or reputational damage. Externalities should be considered to get a complete picture of the project’s overall impact, both good or bad.

While sunk costs should be ignored, opportunity costs and externalities provide valuable information that can affect the project's net benefits. References: Brigham, E. F., & Ehrhardt, M. C. (2020). Financial Management: Theory & Practice (16th ed.). Cengage Learning.