Sunk Costs and Opportunity Costs

A colleague argues that resources that a firm owns already should not be considered in investment analysis, because the cost is a sunk cost. Do you agree?

How would you reconcile the competing arguments of sunk and opportunity costs?

Illustration 6.8: Estimating the Opportunity Cost for a Resource with a Current Alternative Use

Working again with the Bookscape Online example, assume that the following additional information is provided:

• While Bookscape Online will employ only two full-time employees, it is estimated that the additional business associated with on-line ordering, and the administration of the service itself will add approximately 40 hours of work for the current general manager of the bookstore. As a consequence, the salary of the general manager will be increased from $ 100,000 to $ 120,000 next year; it is expected to grow 5% a year after that..

• It is also estimated that Bookscape Online will utilize an office that is currently used to store financial records. The records will be moved to a bank vault, which will cost $ 1000 a year to rent.

The opportunity cost of the addition to the general manager's workload lies in the additional salary expenditure that will be incurred as a consequence. Taking the present value of the after-tax costs (using a 40% tax rate) over the next 5 years, using the cost of capital of 22.76% estimated in illustration 5.2, yields the estimates in Table 6.6:

Table 6.6: Present Value of Additional Salary Expenses
Lessons From The Intelligent Investor

Lessons From The Intelligent Investor

If you're like a lot of people watching the recession unfold, you have likely started to look at your finances under a microscope. Perhaps you have started saving the annual savings rate by people has started to recover a bit.

Get My Free Ebook


Post a comment