Sunk costs and opportunity costs - Masters Golf Products, Inc,, spent 3 years an

Question

Sunk costs and opportunity costs - Masters Golf Products, Inc,, spent 3 years and $1000,000 to develop its new line of club heads to replace a line that is becoming obsolete. To begin manufacturing them, the company will have to invest $1,800,000 in new equipment. The new clubs are expected to generate an increase in operating cash inflows of $750,000 per year for the next 10 years. The company has determined that the existing line could be sold to a competitor for $250,000.

a. How should the $1,000,000 in development costs be classified?

b. How should the $250,000 sale price for the existing line be classified?

c. Depict all of the known relevant cash flows on a time line.

Explanation / Answer

a. How should the $ 1,000,000 in development costs to be classified? Solution The development costs is a sunk cost. Sunk cost is remain the same whether you accept the project or not. The development costs should not be considered part of the decision because when money was spent it cannot be retrieved regardless of whether the project is accepted or rejected. b. How should the $ 2,50,000 sale price for the existing line be classified? Solution The sale price of an existing line to be considered as opportunity cost. Masters Golf Products have the opportunity to sell the old line and receive an income of $ 250,000. c. Depict all of the known relevant cash flows on a time line. Solution Incremental cash flows are cash flows that results directly from the decision to accept the project. They represent the changes in the firms total cash flows that occurs as a direct result of accepting the project. So, the incremental cash flows are relevant to the accept or reject decisions. The incremental cash flows can be classified into three different categories: 1. Total Initial Investment: Cash flows that occur only at the start of the project?s life, year 0. 2. Operating Cash Flows: Cash flows that continuously occur throughout the project's life, years 1 to n. 3. Terminal Cash Flow: Cash flow that occurs only at the end, or the termination, of the project, year n. Relevant cash flows at the start of the project (Year 0): Total Initial Investment = Sale of old line - Initial Investment =                          = $250,000 - $1,800,000 =                          = - $1,550,000 Operating Cash Flows (Years 1 to 10): Increase in operating cash inflows = $750,000 Terminal Cash Flows (End of year 10): Not determined, so we can assume that the project has a life longer than 10 years. For the purposes of this problem the terminal cash flow is zero. Relevant cash flows on a time line (in thousands): YEARS: 0    1     2     3     4     5     6     7     8     9    10 |    |     |     |     |     |     |     |     |     |     | -I----I-----I-----I-----I-----I-----I-----I-----I-----I-----I-----> |    |     |     |     |     |     |     |     |     |     | | $750 $750 $750 $750 $750 $750 $750 $750 $750 $750 | ($1,550)

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