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We have seen in the previous article that estimating cash flows can be quite confusing and counterintuitive. This is not because they are difficult to calculate. It is just because the course of action taken is opposite to what would have been taken in the case of accounting. Accounting is concerned with matching expenses to the relevant period. But in cash flow analysis, the matching concept doesn’t apply! Also, implicit costs are sometimes used in calculation. This article will look forward at clearing some more of those confusions.
Opportunity costs are notional or implicit costs. This means that the money never actually leaves our pockets. They are not expenditures in reality. Rather, they are fictional expenditures. Opportunity cost is the value of the next best alternative which has been foregone to allocate resources to a project.
Let’s consider a scare resource i.e. your time. Let’s say reading and watching movies are the only two possible alternative uses that you could have made of your time. So, each time you watch a movie, you are not reading and each time you read, you are not watching a movie. Therefore, reading is the opportunity cost (next best alternative) of movies and vice versa.
Similarly, when the firm invests its money in project A, it is automatically not investing its money in project B. So the returns of project B (which we did not earn in reality) have to be foregone. The objective of capital budgeting is to ensure that the company can make the best possible choice when faced between conflicting alternatives. So it is imperative that the alternative must be accounted for.
It is for this reason that the opportunity cost of project B should be taken in to account while deciding whether or not project A must be undertaken. Thus, opportunity costs which are not a type of explicit cost and which would have simply been ignored in accounting are being used in cash flow calculations for corporate finance.
Estimating this opportunity cost can sometimes be very difficult. If there is a ready market for the asset for which we need to know the opportunity cost then we can use the prices being reflected in the market as a barometer. However, if no ready market exists, the prices have to be estimated. This can sometimes be a problem. Companies can employ trained appraisers to help determine the saleable value which can be used as the opportunity cost.
Another important point is that the opportunity cost of Project A cannot have a value greater than A. If it has a value greater than A, then that project should be selected and A should become the next best alternative, isn’t it?
Just like in case of capital expenditures, we will only consider the incremental cash outflow which results from an increase in working capital because of the new projects. The old working capital should obviously be excluded from any calculations since it will remain unaffected whether or not the project is undertaken.
We need to be careful to calculate the amount of working capital that will be required. This is because the working capital will usually be simply rolled over from one period to another. So, we invest one amount and it keeps rolling on till the end of the project and seldom requires more cash infusions. Many times, this amount may be left over at the end of the project and it is added to the cash inflows while calculating the Net Present Value. Once again, we are doing the counterintuitive. In accounting working capital was always an expense. Here, at the end of the project, we may add it to the cash inflow!
There are still some more peculiarities about cash flow calculations which we will consider in the next article.
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