Chapter 5 • Practical aspects of investment appraisal
the effect of systematically understating NPVs. Strictly, it is probably better in practice
to identify the forecast cash flows month by month and to discount them according to
when they actually are expected to occur. The extent of bias of the year-end assump-
tions and the working capital adjustment is assessed and discussed by Atrill, McLaney
and Pointon (1997).5.4 Which cash flows?
As we saw in Chapter 2, only those cash flows relevant to the decision should be
brought into the appraisal. Cash flows will be relevant only where they will be differ-
ent, depending upon the decision under review. Items that will occur regardless of the
decision should be ignored. For example, where a decision involving a choice as to
whether or not to make a new product would not have an effect on the fixed over-
heads, the fixed overheads should be disregarded when making the decision; they will
be unaffected by it.
Similarly, past costs are irrelevant as they will inevitably be the same whatever
happens in the future. For example, where a machine costing £50,000 one year ago is
under review as to whether or not it should be replaced, the decision should not take
the £50,000 into account. Only the future benefits that could be derived from the
machine, in terms of either proceeds of disposal or cash flow benefits of its retention,
should be considered. The present decision is not whether or not to buy the machine
a year ago; that decision was made over twelve months ago and was either a good or
a bad one. In either case it is not something that can now be altered.Opportunity cash flows
It is not only cash flows that are expected actually to occur that should be taken into
account. Opportunity cash flows are as important as actual cash flows. In the above
example, if the machine has a current market value of £10,000 then one of the cash
flows associated with retaining the machine will be a £10,000 outflow at whatever time
it would be disposed of if the alternative action (disposal) were followed. Obviously,
if the machine is retained this cash flow will not actually occur; nonetheless it should
be taken into account because retention of the machine deprives the business of the
opportunity to dispose of it. The £10,000 represents a difference arising from the deci-
sion. Some opportunity cash flows may be fairly remote from the project under review
and so can quite easily be overlooked unless care is taken. An example of such oppor-
tunity cash flows is losses of sales revenue (and variable costs) of one of the business’s
existing activities as a result of introducing a new one. For example, a chain store con-
templating opening a new branch should not just assess the cash flows of that branch.
It should also consider cash flow changes that might occur in other branches in the
locality as a result. Sales revenue might be lost at existing branches if a new one is
opened.
The high street retailer Next plcmakes the point in its 2007 annual report that
‘When appraising a new store we account for the loss of sales and profit from nearby
stores that we expect to suffer a downturn as a result of the new opening.’
We shall meet other practical examples of relevant and irrelevant costs in Example
5.5 on page 122.