The General Milk Company (GMC) is currently evaluating the NPV of establishing a line of chocolate milk.

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The General Milk Company (GMC) is currently evaluating the NPV of establishing a line of chocolate milk. As part of the evaluation, the company paid a consulting firm $100,000 last year for a test marketing analysis. Is this cost relevant for the capital budgeting decision now confronting GMC’s management?

The answer is no. The $100,000 is not recoverable, so the $100,000 expenditure is a sunk cost, or spilled milk. In other words, one must ask, “What is the difference between the cash flows of the entire firm with the chocolate milk project and the cash flows of the entire firm without the project?” Because the $100,000 was already spent, acceptance of the project does not affect this cash flow. Therefore, the cash flow should be ignored for capital budgeting purposes.

Of course, the decision to spend $100,000 for a marketing analysis was a capital budgeting decision itself and was perfectly relevant before it was sunk. Our point is that once the company incurred the expense, the cost became irrelevant for any future decision.

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Corporate Finance

ISBN: 9781265533199

13th International Edition

Authors: Stephen Ross, Randolph Westerfield, Jeffrey Jaffe

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