Question

In mid‐ 2009, the Obama administration announced it would cancel orders for a new fleet of presidential helicopters. About $ 3 billion had already been spent on developing the helicopters, which had special protective and telecommunications features. But another $ 8 billion would have been needed to complete the project and deliver the fleet. The administration suggested it might look for a less expensive design and start from scratch. Some media commentators criticized the decision, arguing that cancelling the project would mean wasting the $ 3 billion already spent.

a. Suppose that starting from scratch on a new proposal that would be just as good as the original would cost a total of $ 5 billion from beginning to end. Which would be the wiser choice—sticking with the original or starting from scratch? Why?

b. Would your answer change if the new proposal would cost a total of $ 10 billion? Why or why not?

Answer 1

(a) Starting from scratch would be a better option, because the original proposal will require an additional $8 billion to complete the project while starting from scratch will required only $5 billion. Therefore there will be an incremental saving of $3 million (= $8 million - $5 million) if it is started from scratch.

(b) If new proposal costs $10 billion, then the original proposal is better, since incremental cost will be $8 billion for the original one, in comparison to the incremental cost of $10 billion for the new proposal, which is higher by $2 billion. Since the $3 billion spent on development of the project has already been incurred and cannot be recovered, this is sunk cost and excluded from incremental cash flow analysis.