Reading: Incremental Net Cash Flows

A sunk cost is a cost that has already been incurred (or committed to) and cannot be recovered. The associated cash flows therefore have occurred or will occur regardless of our project decision. Consequently, sunk costs are not incremental and should be ignored in the valuation of projects!

Example 1

Suppose a company has invested $100 million in the development of a new drug. Now the question is whether it should invest another $50 million to launch the drug globally. According to the latest market estimates, the present value of the future incremental net cash flows associated with the drug is $120 million. Should the firm invest?

The answer is yes. From today's perspective, the $100 million are irrelevant. They have been spent and cannot be recovered. They are sunk. Only the incremental investments and benefits matter:

NPV =  − Incremental Investments + Incremental Benefits = − 50 + 120 = 70 million.

As of today, the project therefore has a positive NPV of $70 million. The firm should launch the drug globally.

On hindsight, the drug was a bad investment overall. The total costs of $150 million exceed the total benefits of $120 million. Yet today, we cannot change the original decision to spend $100 million for the development of the drug. That money is gone and we should let bygones be bygones. 

Example 2

To launch a new product, a firm has contracted an external consulting firm to conduct extensive market research. The total costs are CHF 500'000, payable in one year. How should we reflect these costs in the valuation of the project?

The answer is not at all. The firm has a contractual obligation to pay CHF 500'000 to the external consulting firm. Even though this cash flow will occur in the future, the firm has already committed to. Whether or not it launches the product does not change this commitment. Hence, it is not incremental and should therefore be ignored.