Landmine #2 – Landmine #2 – Sunk CostsSunk Costs©Dr. B. C. Paul 2002 revisions 2008©Dr. B. C. Paul 2002 revisions 2008

Note – The subject covered in these slides is considered to be “common Note – The subject covered in these slides is considered to be “common knowledge” to those familiar with the subject and books or articles knowledge” to those familiar with the subject and books or articles covering the concepts are widespread. covering the concepts are widespread.

The Sunk Costs Booby The Sunk Costs Booby TrapTrap

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

Example ContinuedExample Continued

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

Cash FlowCash Flow

-3 -2 -1 0 1 2

3 4 5 6 7 8 9 10 11 12

-400,000,000

-150,000,000

-1,000,000,000

650,000,000/year

Where is the point of decision?

What Kind of Problem is this?

Invest and Earn Problem

-100,000,000

Sweeping Into the PotSweeping Into the Pot

-3 -2 -1 0 1 2

3 4 5 6 7 8 9 10 11 12

-400,000,000

-150,000,000

-1,00,000,000

650,000,000/year

-$150,000,000 * 0.833 = -$124,950,000

-$1,000,000,000* 0.6944 = -$694,000,000

$650,000,000 * 4.192 =$2,724,800,000*

What Did I Forget to Do?

* 0.6944 = $1,892,101

Sum Up = $972,999,000

-$100,000,000

-100,000,000

Wrapping UpWrapping Up

-3 -2 -1 0 1 2

$973,000,000 NPV

What About My $1,200,000,000 Investment to Find That Oil Field

Sunk CostsSunk Costs

Can your decision change whether that cost occurs?

What Do You Do With a What Do You Do With a Sunk CostSunk Cost

You keep it out of the cash flow.You keep it out of the cash flow. Your job is to pick the best alternative Your job is to pick the best alternative

from the things you can controlfrom the things you can control ““Crying over spilt milk” doesn’t do the jobCrying over spilt milk” doesn’t do the job

How Do You RecognizeHow Do You Recognize

One give away is that the cost occurred One give away is that the cost occurred in the past and the money is spentin the past and the money is spent Be careful though – sometimes tax Be careful though – sometimes tax

consequences will differ going forwardconsequences will differ going forward

Key Question – Does my choice change Key Question – Does my choice change whether this cost occurs?whether this cost occurs? If no then don’t include itIf no then don’t include it

Are Sunk Costs Always in Are Sunk Costs Always in the Past?the Past?

No – someone can have made an No – someone can have made an irretrievable commitment going forwardirretrievable commitment going forward Mining ExampleMining Example

Mining company signs a deal with farmer Jones Mining company signs a deal with farmer Jones to mine coal under his landto mine coal under his land

For the rights Mining Company offers a minimum For the rights Mining Company offers a minimum payment of $50,000 per year for the next 5 yearspayment of $50,000 per year for the next 5 years

If no mine is built what do you pay farmer Jones?If no mine is built what do you pay farmer Jones?