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Chapter 14

2.3 Net present value (NPV)

 Method: discount future cash flows to get their present value.

 NPV gives impact on shareholder wealth, so accept project if NPV > 0

2.4 Internal rate of return (IRR)

 IRR = discount rate. when NPV = 0

 IRR = breakeven cost of capital.

2.5 Expected values

 If forecasts are uncertain but probabilities can be attached to the possible
outcomes, expected values (EV) can be calculated.

 EV = (outcome 1 × probability 1) + (outcome 2 × probability 2) + ...

 However, there are limitations:

– EV is a long-run average, so less useful for one-off projects

– EV figure used (e.g. sales volume) may not be a possible outcome

– relying on EVs in isolation loses information about risk, so effectively
ignores risk preferences of investors (or assumes they are risk neutral)

– probabilities very difficult to estimate.

2.6 Sensitivity analysis

Sensitivity analysis can be used:

 to assess the impact on the NPV of a certain change in a particular input factor

 to consider by how much each input variable could change before the NPV of
the project became zero (and hence the project became unacceptable), and
hence to identify key estimates.

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