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Discount Incremental Cash Flows

A project s present value depends on the extra cash flows that it produces. Forecast first the firm s cash flows if you go ahead with the project. Then forecast the cash flows if you don t accept the project. Take the difference and you have the extra (or incremental) cash flows produced by the project:

Incremental = cash flow cash flow cash flow with project without project

Launching a New Product

Consider the decision by Intel to launch its Pentium III microprocessor. A successful launch could mean sales of 50 million processors a year and several billion dollars in profits.

But are these profits all incremental cash flows? Certainly not. Our with-versuswithout principle reminds us that we need also to think about what the cash flows would be without the new processor. Intel recognized that if it went ahead with the Pentium III, demand for its older Pentium II processors would be reduced. The incremental cash flows therefore are Cash flow with Pentium III cash flow without Pentium III (including lower cash flow (with higher cash flow from Pentium II processors) from Pentium II processors)

The trick in capital budgeting is to trace all the incremental flows from a proposed project. Here are some things to look out for.

INCLUDE ALL INDIRECT EFFECTS

Intel s new processor illustrates a common indirect effect. New products often damage sales of an existing product. Of course, companies frequently introduce new products anyway, usually because they believe that their existing product line is under threat from competition. Even if you don t go ahead with a new product, there is no guarantee that sales of the existing product line will continue at their present level. Sooner or later they will decline.

Sometimes a new project will help the firm s existing business. Suppose that you are the financial manager of an airline that is considering opening a new short-haul route from Peoria, Illinois, to Chicago s O Hare Airport. When considered in isolation, the new route may have a negative NPV. But once you allow for the additional business that the new route brings to your other traffic out of O Hare, it may be a very worthwhile investment.

To forecast incremental cash flow, you must trace out all indirect effects of accepting the project.

Some capital investments have very long lives once all indirect effects are recognized. Consider the introduction of a new jet engine. Engine manufacturers often offer attractive pricing to achieve early sales, because once an engine is installed, 15 years sales of replacement parts are almost assured. Also, since airlines prefer to reduce the number of different engines in their fleet, selling jet engines today improves sales tomorrow as well. Later sales will generate further demands for replacement parts. Thus the string of incremental effects from the first sales of a new model engine can run out 20 years or more.

FORGET SUNK COSTS

Sunk costs are like spilled milk: they are past and irreversible outflows.

Sunk costs remain the same whether or not you accept the project. Therefore, they do not affect project NPV.

Unfortunately, managers often are influenced by sunk costs. For example, in 1971 Lockheed sought a federal guarantee for a bank loan to continue development of the Tristar airplane. Lockheed and its supporters argued that it would be foolish to abandon a project on which nearly $1 billion had already been spent. This was a poor argument, however, because the $1 billion was sunk. The relevant questions were how much more needed to be invested and whether the finished product warranted the incremental investment.

Lockheed s supporters were not the only ones to appeal to sunk costs. Some of its critics claimed that it would be foolish to continue with a project that offered no prospect of a satisfactory return on that $1 billion. This argument too was faulty. The $1 billion was gone, and the decision to continue with the project should have depended only on the return on the incremental investment.