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CMA Final · Strategic Financial Management · Investment Decisions, Project Planning and Control

Sagar Textiles is evaluating a new weaving line costing Rs 8,00,000. The company has already spent Rs 50,000 on a feasibility study, and the machine will occupy a shed that could otherwise be rented out for Rs 40,000 a year for 5 years. Which of the following is correct in deciding the project's relevant cash flows?

The Rs 50,000 feasibility cost is sunk and must be ignored, while the Rs 40,000 annual rent forgone is an opportunity cost and must be included as a relevant cash flow, because only incremental future cash flows affect the decision.

  1. AInclude the Rs 50,000 study cost as part of the initial outlay
  2. BIgnore the Rs 50,000 study cost but include the Rs 40,000 annual rent forgone as an opportunity costCorrect
  3. CIgnore both the study cost and the rent forgone since neither is a cash payment
  4. DInclude both the Rs 50,000 study cost and the rent forgone

Explanation

The feasibility study cost is already spent and is a sunk cost, so it is irrelevant. The rent that could be earned from the shed is an opportunity cost and is a relevant incremental cash flow. Option A and D wrongly include the sunk cost; option C wrongly ignores the opportunity cost.

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