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IAI Actuarial Core Principles · Business Economics · Relationship between economics and business

Mehta Textiles has spent ₹8 lakh on a feasibility study, which cannot be recovered. A new machine would cost ₹50 lakh and is expected to give extra revenue of ₹70 lakh with extra operating costs of ₹25 lakh, all in the same period and ignoring discounting. Which statement reflects correct economic reasoning?

The ₹8 lakh study cost is sunk and must be ignored. Incremental net revenue is ₹45 lakh against a machine cost of ₹50 lakh, leaving a loss of ₹5 lakh, so the firm should reject the machine on economic grounds.

  1. AThe study cost should be added, giving total cost of ₹58 lakh and a net gain of ₹12 lakh, so reject
  2. BThe study cost should be subtracted from revenue, giving a net gain of ₹37 lakh
  3. COnly the study cost is relevant because it is the most recent expense
  4. DIgnore the study cost as sunk; the incremental net gain is ₹70 − ₹25 − ₹50 = −₹5 lakh, so rejectCorrect
  5. Ignore the study cost as sunk; the incremental net gain is ₹20 lakh, so accept

Explanation

Sunk costs are irrelevant. Incremental benefit = 70 − 25 = 45 lakh against machine cost 50 lakh, giving −5 lakh. Including the 8 lakh study wrongly changes the analysis; option 4 omits the machine cost correctly handled only as 45−25 error.

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