It should be apparent that in setting up an economic model, the conventional accrual accounting concept, net income after taxes, has been abandoned. The established criterion is cash flow—net income after tax plus noncash charges.
The second step is to adjust the cash flow into relevant financial terms. The cash flow projected for each year over the life of the proposal has to be translated into financial terms that are valid; that is, the annual dollar cash flows must be translated into a common dollar value in a base year. This concept must not be confused with attempts to adjust for changes in the purchasing power of the dollar.
The calculations assume no significant erosion in the purchasing power of the dollar. Should this occur, the time-adjusted common dollar concept may require adjustments for the diminished real value (purchasing power) of future dollar payments. The common dollar value concept used in capital budgeting adjusts for time value only. This is achieved through the development of the concept of discounting and present value that will be examined in the next section. An examination of how a simple two-step model is developed will illustrate the rationale of this approach.
In the first step, we set up the economic model: Benefits minus costs equals cash flow. To complete this model, we need to identify in detail all economic benefits and costs associated with the project. Benefits typically take the form of sales revenues and other income. Costs normally include nonrecurring outlays for fixed assets, investments in working capital, and recurring outlays for payrolls, materials, and expenses.
For each element of benefits and costs that the project involves, we forecast the amount of change for each year. How far ahead do we forecast? For as long as the expenditure decision will continue to have effects: that is, for as long as they generate costs and significant benefits. Forecasts are made for each year of the project's life; we call the year of decision "year 0," the next year "year 1," and so on. When the decision's effects extend so far into the future that estimates are very conjectural, the model stops forecasting at a planning horizon (ten to fifteen years), far enough in the future to establish clearly whether the basis for the decision is a correct one.
We apply a single economic concept in forecasting costs: opportunity cost. The opportunity cost of a resource (asset) is what the company loses from not using it in an alternative way or exchanging it for another asset. For example, if cash has earning power of 15 percent after taxes, we speak of the cash as having an opportunity cost of 15 percent. Whenever an asset is acquired for a cash payment, the opportunity cost is, of course, the cash given up to acquire it. It is harder to establish the opportunity cost of committing assets already owned or controlled. If owned land committed to a project would otherwise be sold, the opportunity cost is the aftertax proceeds from the sale. The opportunity cost of using productive equipment, transportation vehicles, or plant facilities is the incremental profit lost because these resources are unavailable for other purposes. If the alternative to using owned facilities is idleness, the opportunity cost is zero. Although opportunity costs are difficult to identify and measure, they must be considered if we are to describe the economic consequences of a decision as accurately as possible. An understanding of this concept of opportunity cost is probably the most critical to this economic analysis and is generally quite foreign to the manager.
At the end of the first step, we have an economic model for the project's life showing forecast cash flows for each year. In the second step, we convert the results into financial terms that are meaningful for decision making. We must take into account the one measurable financial effect of an investment decision left out in step 1: time. Dollars shown in different years of the model cannot be compared since time makes them of dissimilar value. We clearly recognize that if we have an opportunity to invest funds and earn 15 percent a year and we have a choice of receiving $1,000 today or a year from now, we will take the $1,000 today, so that it can be invested and earn $150. On this basis, $1,000 available a year from now is worth less than $1,000 today. It is this adjustment for time that is required to make cash flows in different years comparable; that is, discounting.
This time value of funds available for investment is known as the opportunity cost of capital. This should not be confused with the cost of raising capital—debt or equity—or with the company's average earnings rate. Like the opportunity cost of any resource, the opportunity cost of capital is what it will cost the company to use capital for an investment project in terms of what this capital could earn elsewhere.
The opportunity cost of capital is alternatively referred to as the minimum acceptable rate of interest, the marginal rate of interest, the minimum rate of return, the marginal rate of return, and the cost of capital. Whatever the term used, and they are used loosely and interchangeably, it reflects the rate the corporation decides it can be reasonably sure of getting by using the money in another way. It is developed through the joint efforts of management, which identifies relevant opportunities, and the controller, who translates management's judgment into a marginal rate.
Another simple economic concept must be introduced: incremental cost, sometimes called differential cost or marginal cost. By definition, it is the change in cost (or revenue) that results from a decision to expand or contract an operation. It is the difference in total cost. In performing the capital budgeting analysis, we deal with incremental costs (revenues) only. Sunk or existing costs are not relevant to the evaluation and decision.