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Explain why sunk costs should not be included in a capital budgeting analysis but opportunity costs and externalities should be included. Give an example of each.

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Sunk costs should not be included in a capital budgeting analysis since sunk costs have already been incurred in the past and is unrecoverable no matter what options have been chosen. In other words, these are costs that are permanently lost, no matter what decisions would be made in the future.

For example, a company incurs $1,000,000 in research costs to assess the viability of a certain project. This cost is a sunk cost since it has been incurred in the past and cannot be recovered whether the company decides to accept or reject the project.

Since future decisions won't affect the recoverability of these costs, these cash flows are irrelevant to capital budgeting decisions and should not be included in the capital budgeting analysis.

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