When doing an NPV analysis of a capital budgeting decision, the Biz Bucks methodology has three basic parts: draw the cash flows using arrow diagrams, use NPV to determine if the project is “NPV positive”, then handle uncertainty through a decision tree.
Getting the cash flows right is usually the toughest part.
The basic rule for decision making is:
ONLY CONSIDER FUTURE CASH FLOWS WHICH VARY BETWEEN THE ALTERNATIVES!
In applying this rule, here are a few things to remember:
One: Disregard sunk cost. Costs in the past have no relevance to the decision. This may be hard because past decisions may look poor in light of sunk costs.
Two: Don’t forget to include opportunity costs. Opportunity costs are benefits (cash inflows) that you forego and miss IF you implement the project under consideration.
Three: Study accounting loads and know what is included in them. Some loads may vary between the alternatives, some may not. Don’t expect your accounting staff people to understand your decision making needs. Know the details of loads yourself.
Four: Don’t forget to subtract 40% for taxes for those operating expenses which appear on the income statement.
Five: Don’t forget to calculate the Depreciation Tax Shield for capital projects. Get help from your financial staff members to use accurate accelerated depreciation schedules.
Once cash flows are correct, doing an NPV analysis is the easy part.