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Landmine #2 – Sunk Costs

Landmine #2 – Sunk Costs. ©Dr. B. C. Paul 2002 revisions 2008 Note – The subject covered in these slides is considered to be “common knowledge” to those familiar with the subject and books or articles covering the concepts are widespread. . The Sunk Costs Booby Trap.

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Landmine #2 – Sunk Costs

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  1. Landmine #2 – Sunk Costs ©Dr. B. C. Paul 2002 revisions 2008 Note – The subject covered in these slides is considered to be “common knowledge” to those familiar with the subject and books or articles covering the concepts are widespread.

  2. The Sunk Costs Booby Trap • Bushy Boys Oil spends $400,000,000 dollars a year for 3 years to find the Dead Seal oil field. The exploration data shows that the oil field contains 100,000,000 barrels of recoverable oil. It will cost $100,000,000 right now and $150,000,000 over the next year to keep building, permitting and bribing – I mean lobbing officials, and running a warm fuzzy PR campaign. It will then cost $1,000,000,000 to develop the wells to pump the oil field and to develop the pipeline infrastructure to move the oil.

  3. Example Continued • It will cost $17/barrel to lift the oil to the surface and another $8.00/barrel to move it to market. If oil will sell for $90/barrel and the oil field will be pumped down evenly over the next 10 years, can the investment yield a 20% rate of return?

  4. Cash Flow Where is the point of decision? What Kind of Problem is this? Invest and Earn Problem 650,000,000/year -3 -2 -1 0 1 2 3 4 5 6 7 8 9 10 11 12 -100,000,000 -150,000,000 -1,000,000,000 -400,000,000

  5. Sweeping Into the Pot -$100,000,000 -$150,000,000 * 0.833 = -$124,950,000 What Did I Forget to Do? -$1,000,000,000* 0.6944 = -$694,000,000 $650,000,000 * 4.192 =$2,724,800,000* * 0.6944 = $1,892,101 Sum Up = $972,999,000 650,000,000/year -3 -2 -1 0 1 2 3 4 5 6 7 8 9 10 11 12 -100,000,000 -150,000,000 -1,00,000,000 -400,000,000

  6. Wrapping Up What About My $1,200,000,000 Investment to Find That Oil Field $973,000,000 NPV -3 -2 -1 0 1 2

  7. Sunk Costs Can your decision change whether that cost occurs?

  8. What Do You Do With a Sunk Cost • You keep it out of the cash flow. • Your job is to pick the best alternative from the things you can control • “Crying over spilt milk” doesn’t do the job

  9. How Do You Recognize • One give away is that the cost occurred in the past and the money is spent • Be careful though – sometimes tax consequences will differ going forward • Key Question – Does my choice change whether this cost occurs? • If no then don’t include it

  10. Are Sunk Costs Always in the Past? • No – someone can have made an irretrievable commitment going forward • Mining Example • Mining company signs a deal with farmer Jones to mine coal under his land • For the rights Mining Company offers a minimum payment of $50,000 per year for the next 5 years • If no mine is built what do you pay farmer Jones?

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