Dave and Ann Stone have been living at their present home for the past 6 years.

Question

Dave and Ann Stone have been living at their present home for the past 6 years. During that time, they have replaced the water heater for $375, have replaced the dishwasher for $599, and have had to make miscellaneous repair and maintenance expenditures of approximately $1,500. They have decided to move out and rent the house for $975 per month. Newspaper advertising will cost $75. Dave and Ann intend to paint the interior of the home and power-wash the exterior. They estimate that that will run about $900. the house should be ready to rent after that. In reviewing the financial situation, Dave views all expenditures as being relevant, and so he plans to net out the estimated expenditures discussed above from the rental income.
a. Do Dave and Ann understand the difference between sunk costs and opportunity costs? Explain the two concepts to them.
b. Which of the expenditures should be classified as sunk cash flows, and which should be viewed as opportunity cash flows?

Explanation / Answer

Sunk costs: These are costs that were incurred in the past. Sunk costs are irrelevant for decisions, because they cannot be changed. Here water heater replacement cost of $375, dishwasher for $599, and miscellaneous repair and maintenance expenditures of approximately $1,500 are Sunk costs. Opportunity cost: The profit foregone by selecting one alternative over another. It is the net return that could be realized if a resource were put to its next best use. It is “what we give up” from “the road not taken.”. So Newspaper advertising and painting the interior of the home and power-wash the exterior are opportunity costs as that will result in good rental income. Had this expense is not incurred, it may take more time to find a tenant or tenant may not be willing to pay a high rental as paint may be peeling or exterior is dirty.

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