Question

1. NPV According to the text, the NPV rule states that "An investment should be accepted if the NPV is positive and rejected if it is negative." What does an NPV of zero mean? If you were a decision-maker faced with a project with a zero NPV (or very close to zero) what would you do? Why?

2. FORECASTING ERROR (RISK) What is a "forecasting error"? Why is it important to the analysis of capital expenditure projects?

Answer 1

1. NPV According to the text, the NPV rule states that "An investment should be accepted if the NPV is positive and rejected if it is negative." What does an NPV of zero mean? If you were a decision-maker faced with a project with a zero NPV (or very close to zero) what would you do? Why?

Positive NPV represents the absolute dollar addition to shareholders' wealth if, the project is undertaken and negative NPV the opposite. Hence, it follows that 0 NPV would mean no addition or reduction to shareholders' wealth if a project is undertaken. The shareholders' are neither better off nor worse off than before.

In such a situation, I would prefer to undertake the project for the following reasons:

*There is no other project which would give a higher NPV.

*Implementing the project [with 0 NPV] would generate economic activity and would result in benefits to other stakeholders, like employees, government by way of contribution to taxes, generation of GDP etc,

2. FORECASTING ERROR (RISK) What is a "forecasting error"? Why is it important to the analysis of capital expenditure projects?

Forecasting error is the situation where the projections as to the project variables, like units demanded, selling price, cost of inputs etc may vary.when the project is implemented. Such variations will cause the actual profitability of the project to vary from the project profitability. Adverse variations may render the project unviable. Hence, it is necessary to know the extent to which the forecasts could vary.