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INCLUDE OPPORTUNITY COSTS

Resources are almost never free, even when no cash changes hands. For example, suppose a new manufacturing operation uses land that could otherwise be sold for $100,000. This resource is costly; by using the land you pass up the opportunity to sell it. There is no out-of-pocket cost but there is an opportunity cost, that is, the value of the forgone alternative use of the land.

This example prompts us to warn you against judging projects before versus after rather than with versus without. A manager comparing before versus after might not assign any value to the land because the firm owns it both before and after:

Comparing the cash flows with and without the project, we see that $100,000 is given up by undertaking the project. The original cost of purchasing the land is irrelevant that cost is sunk.

The opportunity cost equals the cash that could be realized from selling the land now, and therefore is a relevant cash flow for project evaluation.

When the resource can be freely traded, its opportunity cost is simply the market price.1 However, sometimes opportunity costs are difficult to estimate. Suppose that you go ahead with a project to develop Computer Nouveau, pulling your software team off their work on a new operating system that some existing customers are not-sopatiently awaiting. The exact cost of infuriating those customers may be impossible to calculate, but you ll think twice about the opportunity cost of moving the software team to Computer Nouveau.

RECOGNIZE THE INVESTMENT IN WORKING CAPITAL

Net working capital (often referred to simply as working capital) is the difference between a company s short-term assets and liabilities. The principal short-term assets are cash, accounts receivable (customers unpaid bills), and inventories of raw materials and finished goods. The principal short-term liabilities are accounts payable (bills that you have not paid), notes payable, and accruals (liabilities for items such as wages or taxes that have recently been incurred but have not yet been paid).

Most projects entail an additional investment in working capital. For example, before you can start production, you need to invest in inventories of raw materials. Then, when you deliver the finished product, customers may be slow to pay and accounts receivable will increase. (Remember Reggie Hotspur s computer sale, described in

Example 1. It required a $500,000, six-month investment in accounts receivable.) Next year, as business builds up, you may need a larger stock of raw materials and you may have even more unpaid bills.

Investments in working capital, just like investments in plant and equipment, result in cash outflows.

We find that working capital is one of the most common sources of confusion in forecasting project cash flows.2 Here are the most common mistakes:

1. Forgetting about working capital entirely. We hope that you never fall into that trap.

2. Forgetting that working capital may change during the life of the project. Imagine that you sell $100,000 of goods per year and customers pay on average 6 months late. You will therefore have $50,000 of unpaid bills. Now you increase prices by 10 percent, so that revenues increase to $110,000. If customers continue to pay 6 months late, unpaid bills increase to $55,000, and therefore you need to make an additional investment in working capital of $5,000.

3. Forgetting that working capital is recovered at the end of the project. When the project comes to an end, inventories are run down, any unpaid bills are (you hope) paid off, and you can recover your investment in working capital. This generates a cash inflow.

BEWARE OF ALLOCATED OVERHEAD COSTS

We have already mentioned that the accountant s objective in gathering data is not always the same as the investment analyst s. A case in point is the allocation of overhead costs such as rent, heat, or electricity. These overhead costs may not be related to a particular project, but they must be paid for nevertheless. Therefore, when the accountant assigns costs to the firm s projects, a charge for overhead is usually made. But our principle of incremental cash flows says that in investment appraisal we should include only the extra expenses that would result from the project.

A project may generate extra overhead costs, but then again, it may not. We should be cautious about assuming that the accountant s allocation of overhead costs represents the incremental cash flow that would be incurred by accepting the project.

1 If the value of the land to the firm were less than the market price, the firm would sell it. On the other hand, the opportunity cost of using land in a particular project cannot exceed the cost of buying an equivalent parcel to replace it.

NET WORKING CAPITAL Current assets minus current liabilities.

OPPORTUNITY COST Benefit or cash flow forgone as a result of an action.