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CFA Level I · CFA Level I Exam · Capital Investments and Capital Allocation

A company spent 2 million last year on a feasibility study for a new plant. The plant now has a positive NPV of 1.5 million before considering the study cost. Which treatment of the 2 million study cost is most appropriate in the decision?

The study cost should be ignored because it is sunk. It has already been spent and is unaffected by the accept or reject decision. Only incremental future cash flows matter, so the project's NPV stays at 1.5 million and it should be accepted.

  1. AIgnore it, because it is a sunk costCorrect
  2. BSubtract it, which gives an NPV of negative 0.5 million
  3. CAdd it to the initial outlay and reject the project

Explanation

The study cost has already been incurred and will not change whichever decision is made, so it is sunk and irrelevant. Including it would wrongly turn a positive NPV of 1.5 million into a negative one and cause a value-adding project to be rejected.

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