Question

Net present value is based on many estimates and forecasts. What can be done to compensate for the uncertainty of these future variables? A. Decreasing the discount rate B. Nothing C. Using IRR instead D. Sensitivity and scenario analysis

Answer 1

Correct Answer: D. Sensitivity and Scenario Analysis

We will use elimination method and try to remove other options

A. Decreasing the discount rate - reducing the discount rate leads to increase in the cash inflows. However, how do we know the uncertainty of the cash flows of the future has been resolved by this step. This factors only one variable that is the discount rate and that too in one direction-downwards, hence this is eliminated.

B.Nothing- This implies the NPV method itself takes care of uncertainties, this is obviously not true as we have future cash flows, and discount rates that are not very certain to occur.

C. Using IRR instead- IRR also has the same variables as we use in NPV, this will not change or reduce the uncertainty.

D.Sensitivity and Scenario Analysis- Using scenarios we can have various cash flow situations, discount rate situations and then we can see how much each scenario impacts the end result. This will reduce the uncertainty.