GSOE9830 Chap.4 Inflation, Sunk Costs and Incremental Projects
Inflation, Sunk Costs and Incremental Projects
Project forecasts must escalate future cash-flow items to the prices expected when they occur, and different items may follow different inflation rates. Current decisions also exclude past costs that cannot change, except where those costs alter a future tax, royalty or recovery entitlement.
For extensions and brownfield choices, incremental cash flow equals the combined project less the base project, including displacement and shared-cost effects. The input base date and cash-flow date are therefore separate facts, and the escalation exponent must match the number of intervening periods. Relevance is tested with a counterfactual: a future amount belongs only if selecting another alternative changes it.
Historical evidence may improve a forecast even when the original payment is sunk. Owned land or equipment is not automatically free because using it can sacrifice future sale or rental proceeds. A complete incremental schedule makes those opportunity effects visible without reviving irrelevant history.
What this chapter covers
- 01
Price escalation
- 02
Cost escalation
- 03
Sunk cost
- 04
Future tax effect
- 05
Base project
- 06
Incremental cash flow
Worked example · free
Separate sunk history from incremental future cash
- +1Base operating cash is $420,000 less $260,000, or $160,000.
- +1Combined operating cash is $535,000 less $318,000, or $217,000.
- +1Difference before displacement is $57,000.
- +1Subtract $12,000 displaced contribution to get $45,000.
Key terms
- Escalation
- Increasing a current estimate to the nominal amount expected in a future year.
- Sunk cost
- A past payment that the current decision cannot change.
- Base project
- The cash-flow path that continues without the proposed change.
- Incremental project
- The cash-flow difference created by accepting the proposed change.
Inflation, Sunk Costs and Incremental Projects FAQ
Why escalate costs separately?
Steel, labour, energy and selling price can grow at different rates. Separate escalation preserves those drivers and makes sensitivity analysis possible instead of hiding them in one blended assumption.
Can a sunk cost ever matter?
The payment itself cannot change, but a future tax deduction, royalty effect or cost-recovery entitlement caused by that payment can change future cash flow and should be included.
What is the safest incremental formula?
Construct the combined-project cash flow and subtract the base-project cash flow period by period. Then add displacement, shared-cost and tax interactions that the proposal causes.
Exam move
Prepare an input register before building the incremental model. For every amount, record its base date, cash-flow date, escalation rate, whether it is already paid, whether the current decision can change it and whether it creates a future tax or recovery effect. This register separates three questions that are often confused: when the price is measured, when cash moves and whether the amount is relevant to the choice.
Escalate physical drivers individually. Apply the material rate to material cost, labour rate to labour and selling-price growth to revenue rather than multiplying a completed net cash-flow total by one general factor. Write the exponent beside the date count and check the convention for beginning versus end of year. Keep unrounded values through the schedule and round only the reported cash flow.
When the problem supplies real amounts instead, label them clearly and postpone inflation treatment until the nominal-real basis is chosen. Use the counterfactual test for relevance: if another alternative is selected, will this future cash flow change? A historical design payment that cannot be recovered is sunk and drops out of the ranking.
The information produced by the design work may still improve estimates, and a future deduction or refund connected to it may remain relevant. Separate the past principal from that future consequence rather than keeping or discarding both automatically. Construct brownfield and extension cases in three rows: base project, combined project and combined minus base.
Include displaced production, shared-cost changes, opportunity costs and tax interactions that the proposal causes. Common revenue and expense should cancel. Test the model by removing the proposal and confirming the incremental row becomes zero in every period. If a shared item survives unchanged, revisit the subtraction. Practise opportunity cost with an owned site or idle machine.
Historical purchase price is sunk, but sale proceeds or rental income forgone by project use is a future difference. Place the forgone amount at the date it is sacrificed and keep it distinct from an invented current purchase price. This exercise prevents the word owned from being mistaken for free. Stress the model by changing the start date, one escalation rate and the amount of displaced output.
Explain which rows move and why. A good answer does not merely produce a new NPV; it identifies the operational link between the assumption and incremental cash flow. Keep an error log for blanket escalation, wrong exponent, sunk payment retained, future tax effect discarded, base case omitted, displacement ignored and opportunity cost confused with accounting cost.
Before submission, label each surviving line as a future difference and state the alternative against which it is measured. The model is complete only when every included amount passes both tests: it occurs in the future and it changes because of the decision.