298 Planning and Forecasting
later. Since the cash f low is deferred, the true value of that sale to the firm is
somewhat diminished.
By focusing on cash f lows and when they occur, NPV ref lects the true
value of increased revenues and costs. Consequently, NPV analysis requires
that accounting data be unraveled to reveal the underlying cash f lows. That is
why changes in net working capital must be accounted for and why deprecia-
tion does not show up directly.
Principle No. 2: Use Expected Values
There is always going to be some uncertainty over future cash f lows. Future
costs and revenues cannot be known for sure. The analyst must gather as much
information as possible and assemble it to construct expected values of the
input variables. Although expected values are not perfect, these best guesses
have to be good enough. What is the alternative? The uncertainty in forecast-
ing the inputs is accounted for in the discount rate that is later used to discount
the expected cash f lows.
Principle No. 3: Focus on the Incremental
NPV analysis is done in terms of “incremental” cash flows—that is, the change
in cash f low generated by the decision to undertake the project. Incremental
cash f low is the difference between what the cash f low would be with the proj-
ect and what the firm’s cash f low would be without the project. Any sales or
savings that would have happened without the project and are unaffected
by doing the project are irrelevant and should be ignored. Similarly, any costs
that would have been incurred any way are irrelevant. It is often difficult yet
nonetheless important to focus on the incremental when calculating how cash
f lows are impacted by opportunity costs, sunk costs, and overhead. These trou-
blesome areas will be elaborated on next.
Opportunity Costs
Opportunity costs are opportunities for cash inf lows that must be sacrificed in
order to undertake the project. No check is written to pay for opportunity
costs, but they represent changes in the firm’s cash f lows caused by the project
and must, therefore, be treated as actual costs of doing the project. For exam-
ple, suppose the firm owns a parking lot, and a proposed project requires use of
that land. Is the land free since the firm already owns it? No; if the project
were not undertaken then the company could sell or rent out the land. Use of
the company’s land is, therefore, not free. There is an opportunity cost. Money
that could have been earned if the project were rejected will not be earned if
the project is started. In order to ref lect fully the incremental impact of the
proposed project, the incremental cash f lows used in NPV analysis must incor-
porate opportunity costs.