In Too Deep: The Effect of Sunk Costs on Corporate Investment

Abstract

Sunk costs are unrecoverable costs that should not affect decision making. I provide evidence that firms systematically fail to ignore sunk costs and that this leads to significant investment distortions. In fixed-exchange-ratio stock mergers, aggregate market fluctuations after parties enter into a binding merger agreement induce plausibly exogenous variation in the final acquisition cost. These quasi-random cost shocks strongly predict firms' commitment to an acquired business following deal completion, with an interquartile cost increase reducing subsequent divestiture rates by 8% to 9%. Consistent with an intrapersonal sunk cost channel, distortions are concentrated in firm-years in which the acquiring CEO is still in office.