Opportunity Costs

When we think of costs, we normally think of out-of-pocket costs, namely, those that require us to actually spend some amount of cash. An opportunity cost is slightly different; it requires us to give up a benefit. A common situation arises in which a firm already owns some of the assets a proposed project will be using. For example, we might be thinking of converting an old rustic cotton mill we bought years ago for $100,000 into upmarket condominiums.

If we undertake this project, there will be no direct cash outflow associated with buying the old mill because we already own it. For purposes of evaluating the condo project, should we then treat the mill as "free"? The answer is no. The mill is a valuable resource used by the project. If we didn't use it here, we could do something else with it. Like what? The obvious answer is that, at a minimum, we could sell it. Using the mill for the condo complex thus has an opportunity cost: we give up the valuable opportunity to do something else with the mill.1

There is another issue here. Once we agree that the use of the mill has an opportunity cost, how much should we charge the condo project for this use? Given that we paid $100,000, it might seem that we should charge this amount to the condo project. Is this correct? The answer is no, and the reason is based on our discussion concerning sunk costs.

The fact that we paid $100,000 some years ago is irrelevant. That cost is sunk. At a minimum, the opportunity cost that we charge the project is what the mill would sell for opportunity cost

The most valuable alternative that is given up if a particular investment is undertaken.

'Economists sometimes use the acronym TANSTAAFL, which is short for "There ain't no such thing as a free lunch," to describe the fact that only very rarely is something truly free.

314 PART FOUR Capital Budgeting today (net of any selling costs) because this is the amount that we give up by using the mill instead of selling it.2

0 0

Post a comment