The Voetmann Consulting Corp. devotes one wing of its suite of offices to a library requiring a cash outflow of $100,000 a year in upkeep. A proposed capital budgeting project is expected to generate revenue equal to 5 percent of the overall firm’s sales. An executive at the firm, David Pedersen, argues that $5,000 ( = .05 × $100,000 ) should be viewed as the proposed project’s share of the library’s costs. Is this appropriate for capital budgeting?

The answer is no. One must ask what the difference is between the cash flows of the entire firm with the project and the cash flows of the entire firm without the project. The firm will spend $100,000 on library upkeep whether or not the proposed project is accepted. Because acceptance of the proposed project does not affect this cash flow, the cash flow should be ignored when calculating the NPV of the project. Suppose the project has a positive NPV without the allocated costs but is rejected because of the allocated costs. In this case, the firm is losing potential value that it could have gained otherwise.