Question6 When building a project’s incremental cash flows, a sunk cost should be:Select one alternative: Included as an outflow at t = 0 Included, but only on an after-tax basis Spread over the life of the project as depreciation Excluded, because it has already been incurred and does not change with the decision ResetMaximum marks: 2 Flag question undefined

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Question6 When building a project’s incremental cash flows, a sunk cost should be:Select one alternative: Included as an outflow at t = 0  Included, but only on an after-tax basis Spread over the life of the project as depreciation Excluded, because it has already been incurred and does not change with the decision ResetMaximum marks: 2 Flag question undefined

BlackTom AI · Accepted Answer

A sunk cost is a past expenditure that cannot be recovered and therefore should not affect future decision-making.

1. Relevant knowledge points and concepts
- Incremental (or relevant) cash flows: only cash flows that change as a direct result of accepting or rejecting the project should be included in NPV and other capital budgeting calculations.
- Sunk cost: a cost already incurred and irreversible; by definition it does not change regardless of the decision.
- Decision rule: exclude sunk costs from incremental cash flows; include opportunity costs and any future tax effects or salvage values that change with the decision.

2. Step-by-step reasoning
- Identify whether the cost is avoidable or unavoidable. A sunk cost is unavoidable because it’s already spent.
- Determine incremental effect: since the sunk cost will be incurred whether or not the project proceeds, it does not alter the difference in cash flows between the project and the status quo.
- Therefore it should not enter the cash flow stream used for NPV, IRR, or similar analyses.

3. Intermediate/calculation illustration
- Suppose a firm already spent $100,000 on a feasibility study (sunk). The project will generate future cash inflows with PV = $300,000 and require a new investment of $150,000 today. Correct NPV = PV(future inflows) − new investment = 300,000 − 150,000 = 150,000. If the sunk $100,000 were erroneously included, NPV would be 50,000, which understates the true incremental benefit and could lead to a wrong decision.

4. Why the correct answer is correct
- Because sunk costs do not change regardless of the project decision, they do not affect incremental cash flows and must be excluded. Including them biases NPV and other metrics and violates the principle of only using relevant (future, incremental) cash flows.

5. Why the other options are incorrect
- “Included as an outflow at t = 0”: Incorrect because that double-counts past expenditures that are not affected by the decision.
- “Included, but only on an after-tax basis”: Incorrect — tax treatment is irrelevant for a cost that no longer affects future taxable income related to the project decision.
- “Spread over the life of the project as depreciation”: Incorrect — depreciation applies to capital expenditures that are part of the project and affect taxes in the future; a sunk cost already incurred cannot be depreciated in the project’s incremental cash flows unless it legitimately creates a new tax basis (rare and not the typical sunk-cost case).

6. Conclusion
The correct choice is “Excluded, because it has already been incurred and does not change with the decision,” which matches the provided answer.

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