The reason for not considering the sunk cost in capital budgeting analysis and for considering the opportunity cost and externalities. Introduction: Sunk Cost: The cost that is not based on the acceptance or rejection of a decision is called sunk cost. It is an already incurred cost before taking decision about the project and can’t be adjusted or recovered. Opportunity Cost: The loss of estimated income due to the rejection of a project is known as opportunity cost. It is considered as an important factor for capital budgeting decisions. Externalities: The cost to eliminate the effect of an alternative on other parties that are not involved in the decision making is called externalities cost. It is considered along with other factors, to accept or reject an alternative.

Question

An insurance company has liabilities of £7 million due in 10 years' time and £9 million due in 17 years' time. The assets of the company consist of two zero-coupon bonds, one paying £X million in 7 years' time and the other paying £Y million in 20 years' time. The current interest rate is 6% per annum effective. Find the nominal value of X (i.e. the amount, IN MILLIONS, that bond X pays in 7 year's time) such that the first two conditions for Redington's theory of immunisation are satisfied. Express your answer to THREE DECIMAL PLACES.

Answer 1

Question

Chapter 12, Problem 2Q

Summary Introduction

To explain: The reason for not considering the sunk cost in capital budgeting analysis and for considering the opportunity cost and externalities.

Introduction:

Sunk Cost:

The cost that is not based on the acceptance or rejection of a decision is called sunk cost. It is an already incurred cost before taking decision about the project and can’t be adjusted or recovered.

Opportunity Cost:

The loss of estimated income due to the rejection of a project is known as opportunity cost. It is considered as an important factor for capital budgeting decisions.

Externalities:

The cost to eliminate the effect of an alternative on other parties that are not involved in the decision making is called externalities cost. It is considered along with other factors, to accept or reject an alternative.

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