Sunk Cost - International Finance and Banking

American University in Bosnia and Herzegovina

INTERNATIONAL FINANCE AND BANKING

[pic 1]HOMEWORK

SUNK COST

Student: Sajra Čarkadžić

Course: FSMA 201

Professor: Sanda Putica

Date: 10/12/2015

Sunk cost represents costs which are incurred in the past and cannot be recovered or refunded in the future. Due to this, sunk costs are not needed in capital budgeting analysis and they do not depend on acceptance or rejection of a project. They also should not be taken into consideration of a future projects and decision making because sunk costs happened in the past and they do not have any impact on the future. ^[1]

Examples of sunk cost from real life are paying a rent for an apartment or paying a bill in a restaurant. You get something in return, home or food, but you could never get that money back. Examples of sunk cost from economic life are investigation, research, or investment in new project. ^[2]No matter which project and how would be accepted, rejected, or done, those costs could not be refunded.

When making a decision, people are always looking at cost. But sunk cost is not a type normal cost because it is a permanent lost. ^[3]No matter what happens, people are always afraid of a loss.^[4] They are misunderstanding the economic rules in capital budgeting and making irrational decisions.

There is one term which is connected with sunk cost. It is a sunk cost fallacy. For example, you have paid for a one-day trip to Mostar six months earlier and were excited to go. But how that day is approaching, you want less to go. You have two options: to go unwillingly to Mostar and spend whole day doing something you do not want to. Just because you feel obligated and bad because of paying price, you will go. On the other hand, there is option two which gives you an opportunity not to go to Mostar and do something you like. No matter what, paid trip is a sunk cost, you cannot return that money. Due to the sunk cost fallacy people, unconsciously, do things that worsen them. First option includes waste of money and waste of time, but second option includes only waste of money. Rationally looking, second option is better off but people more often choose first option. ^[5] People are not aware of possibility of making better outcomes from bad decisions.

When assessing should one project (independent) be taken or not, economists are looking at NPV. If project’s NPV is higher than zero, it should be accepted. For example, obtaining a new software patent would cost $2 million. This is a sunk cost. Further research has shown that a company needs additional $17 million in producing the new software. So, in total, it spent $19 million. When calculating their NPV which is $-1 million, project should be rejected. But in matter effect, they included sunk costs and got the wrong NPV. If they disregarded sunk costs, they would get positive NPV and start the production of new software. ^[6] This is why sunk costs should not be taken into account when analyzing capital budget.