292 Planning and Forecasting
decision rule. The perspective of financial analysis is that capital investment
belongs to the investors. The goal of the firm is to maximize investors’ wealth.
Other factors are important and should be considered, but this is the primary
objective. In the case of nonprofit organizations, wealth and return on invest-
ment need not be measured in dollars and cents but rather can be measured in
terms of benefits to society. But in the case of for-profit companies, wealth is
monetar y.
A project creates wealth if it generates cash f lows over time that are
worth more in present-value terms than the initial setup cost. For example,
suppose a brewery costs $10 million to build, but once built it generates a
stream of cash f lows that is worth $11 million. Building the brewery would cre-
ate $1 million of new wealth. If there were no other proposed projects that
would create more wealth than this, then the beer company would be well ad-
vised to build the new brewery.
This example illustrates the “net present value” rule. Net present value
(NPV) is the difference between the setup cost of a project and the value of
the project once it is set up. If that difference is positive, then the NPV is
positive and the project creates wealth. If a firm must choose from several
proposed projects, the one with the highest NPV will create the most wealth,
and so it should be the one adopted. For example, suppose the beer company
can either build the new brewery or, alternatively, can introduce a new prod-
uct—a light beer, for example. There is not enough managerial talent to over-
see more than one new project, or maybe there are not enough funds to start
both. Let us assume that both projects create wealth: The NPV of the new
brewery is $1 million, and the NPV of the new-product project is $500,000. If
it could, the beer company should undertake both projects; but since it has to
choose, building the new brewery would be the right option because it has
the higher NPV.
COMPUTING NPV: PROJECTING CASH FLOWS
The first step in calculating a project’s NPV is to forecast the project’s future
cash f lows. Cash is king. It is cash f low, not profit, that investors really care
about. If a company never generates cash f low, there can be no return to in-
vestors. Also, profit can be manipulated by discretionary accounting treat-
ments such as depreciation method or inventory valuation. Regardless of
accounting choices, however, cash f low either materializes or does not. For
these reasons, cash f low is the most important variable to investors. A project’s
value derives from the cash f low it creates, and NPV is the value of the future
cash f lows net of the initial cash outf low.
We can illustrate the method of forecasting cash f lows with an example.
Let us continue to explore the brewery project. Suppose project engineers in-
form you that the construction costs for the brewery would be $8 million. The