In evaluating a project, should sunk costs be included in the cash flow analysis?

In evaluating a project, should sunk costs be included in the cash flow analysis?

• A. No; only incremental cash flows should be considered.
• B. Yes; all historical costs should be included.
• C. Only if they relate to current year expenditures.
• D. It depends on the size of the project.

Answer: (A)

Sunk costs are money already spent and cannot be recovered, so they shouldn’t affect future decisions. When evaluating a project, focus on incremental cash flows—the additional cash inflows and outflows that will occur if you undertake the project versus if you do not. This keeps the analysis tied to future value creation rather than past spending. For example, if a firm has already paid for equipment, that past payment is irrelevant to the decision about a new project. What matters are future changes in cash flows, such as expected revenues, operating costs, taxes, and any potential salvage value from existing assets. If salvage value is possible, include it as part of the future cash flows. Other ideas would incorrectly bring in past expenditures or tie relevance to the year of spending or project size, which would distort the true incremental value of taking on the project.

Sunk costs are money already spent and cannot be recovered, so they shouldn’t affect future decisions. When evaluating a project, focus on incremental cash flows—the additional cash inflows and outflows that will occur if you undertake the project versus if you do not. This keeps the analysis tied to future value creation rather than past spending.

For example, if a firm has already paid for equipment, that past payment is irrelevant to the decision about a new project. What matters are future changes in cash flows, such as expected revenues, operating costs, taxes, and any potential salvage value from existing assets. If salvage value is possible, include it as part of the future cash flows. Other ideas would incorrectly bring in past expenditures or tie relevance to the year of spending or project size, which would distort the true incremental value of taking on the project.