53.12
12. You are finalizing your capital
budgeting analysis on whether to proceed with a new plant and are
almost ready to present it to your boss. One of your particularly
lazy and dim-witted team members comes sauntering in at the last
minute and starts arguing about some of the details. He states
that the analysis should not have included the land that the
plant will be built-on because it's already bought and paid-for.
He further argues that you've neglected to include the cost of
the exploratory engineering design completed last year when this
project was first conceived. Explain exactly what is wrong with
his arguments. [6 pts]
We may have already bought the land and currently own it, but using represents an opportunity cost for the project. That is, if we didn't use the land in the project, we could use it elsewhere or sell it. Thus with the project, we eliminate its value in alternative uses and must recognize that as a cost. As for the engineering design, that is a sunk cost. Whether we do the project or not, we have spent the money on the design and cannot get it back. This differs from an opportunity cost in that it has no value in any alternative use. That is, even though moving forward with this project requires us to use an engineering design for which we have already paid, there is nothing else we could have done with it anyway and by using it we don't preclude ourselves from using it elsewhere.