Module 2

2.1 Evaluating NPV Estimates

The NPV estimates are just that – estimates. A positive NPV is a good start – now we need to take a closer look. For
instance:

Forecasting risk – how sensitive is our NPV to changes in the cash flow estimates? The more sensitive, the greater
the forecasting risk
Identifying the sources of value – why does this project create value?

Calculating NPVs is just valuing uncertain future cash flows. Errors include biases and omissions:

The Basic Problem

Two reasons for positive NPV:

1) a good project, or

2) a bad job of estimating NPV.

Similarly, a negative NPV may be a bad project or a bad job of estimating NPV.

Projected versus Actual Cash Flows

Estimated cash flows are expectations or averages of possible cash flows, not exact figures (although, of course, if an
exact figure were available you'd use it).

Forecasting Risk
Forecasting risk—the danger of making a bad (money losing) decision because of errors in projected cash flows. This
risk is reduced if we systematically investigate common problem areas.

Sources of Value
The first and best guard against forecasting risk is to keep in mind that positive NPVs are considered economic rarities.
For a project to have a positive NPV, it must have some competitive edge—be first, be best, be the only. Keep in mind
the economic axiom that in a competitive market excess profits (the source of positive NPV) are zero.

Perhaps the single largest source of positive NPVs are monopoly rents profits above those necessary to keep resources
employed in an endeavor that accrue as the result of being the only one able or allowed to do something. Often
associated with patent rights and technological edges, such rents quickly dissipate in a competitive market.

In "Corporate Strategy and the Capital Budgeting Decision" (Midland Corporate Finance Journal, Spring, 1985, pp. 22-
36), Alan Shapiro states that a firm's capital budgeting program should "establish strategic options in order to gain
competitive advantage." Further, successful investments, according to Shapiro, are those investments "that involve
creating, preserving, and even enhancing competitive advantages that serve as barriers to entry."

Below are project characteristics associated with positive NPVs. That is, projects with one or more of these attributes
are more likely to be successful than those without.

Economies of scale
Product differentiation
Cost advantages
Access to distribution channels
Favorable government policy

Activity 2.1: Independent Activity

What is forecasting risk? Why is it a concern for the financial managers?