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Accounting profit often mixes variables whose timings differ. A sale made today may show up in
today‟s profits, but since the cash receipt for the sale may be deferred, the corresponding cash flow
takes place later. Since the cash flow is deferred, the true value of that sale to the firm is somewhat
diminished.
By focusing on cash flows and when they occur, NPV reflects the true value of increased revenues
and costs. Consequently, NPV analysis requires that accounting data be unraveled to reveal the
underlying cash flows. That is why changes in net working capital must be accounted for and why
depreciation does not show up directly.
Principle No. 2: Use Expected Values
There is always going to be some uncertainty over future cash flows. 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 forecasting the inputs is
accounted for in the discount rate that is later used to discount the expected cash flows.
Principle No. 3: Focus on the Incremental
NPV analysis is done in terms of incremental cash flows—that is, the change in cash flow generated
by the decision to undertake the project. Incremental cash flow is the difference between what the cash
flow would be with the project and what the firm‟s cash flow 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 anyway are
irrelevant. It is often difficult (yet nonetheless important) to focus on the incremental when calculating
how cash flows are impacted by opportunity costs, sunk costs, and overhead. These troublesome areas
will be elaborated on next.
Opportunity Costs
Opportunity costs are opportunities for cash inflows 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
flows caused by the project and must therefore be treated as actual costs of doing the project. For
example, 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 reflect fully the incremental impact of the proposed project, the incremental cash
flows used in NPV analysis must incorporate opportunity costs.