The Solicitation Process
The disclosure statement is only the first step in the bankruptcy process. After the solicitation statement has been approved by the court, the ground is set for the negotiations to begin. This is a complicated stage. This is where stakeholders often form groups to connive against the others, and horse-trading takes place. The solicitation process […]
Why Doesn’t the Private Sector Invest In Infrastructure Projects?
As explained in the previous articles, the infrastructure sector is facing a significant funding gap. There is an urgent need to double the spending on infrastructure projects. One of the ways to fulfill this gap is by increasing the participation of the private sector in infrastructure projects. At the present moment, the private sector is […]
Key Terms and Conditions in a Term Sheet of Startup Funding
In the previous article, we have already learned that term sheets are the basis on which the entire relationship between the entrepreneur and the investor rests. Since there are several different aspects to running a business, there are several key terms and conditions which need to be worked out between the two parties. A collaborative […]
Hindsight Bias
There are several cognitive biases that affect our ability to think clearly about financial investments. One such bias is called the hindsight bias. Over the years, the effect of hindsight bias on the value of investor portfolios has been significant. This is the reason that we will have a closer look at what this bias […]
Poor Risk Management at the Silicon Valley Bank
The entire world is still trying to grapple with the failure of the Silicon Valley Bank. The impact has been felt across the United States economy and even across the entire world. It is obvious that since the impact has been significant, a lot of time will be spent trying to analyze if this financial […]
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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