Question

1. Business people point out that the documentation for capital budgeting proposals is often quite impressive. Cash flows are projected down to the last thousand dollars (or even the last dollar) for each year (or even each month). Opportunity costs and side effects are handled quite properly. When a high net present value appears at the bottom, one’s temptation is to say yes immediately. Nevertheless, the projected cash flow often goes unmet in practice, and the firm ends up with a money loser. Explain how can the firm get the net present value technique to live up to its potential and before actual funding, how one can check out the project’s underlying assumptions about revenues and costs?

Answer 1

It is very much necessary to check the various scenerios of revenues and costs before an Investor hands funds only basis the Net Present Value. The reason in case the projected revenues and costs go wrong, the NPV will also go wrong.

Few checks to do initially are :

1. Check the reasonableness of all assumptions behind the revenue forecast. This can include :
a. Check on how big is the market and how easy is entry into the market.
b. Check reasonableness of growth of revenue. Is it coming by growth of market. If yes are the assumptions of market growing that the pace are correct. Or is it coming by increase in market share. Do the assumptions seem genuine.
c. Check if any similar such companies, how have their revenues grown over time.
d. If the loyalty of the consumers in the market is high towards the old products, the revenue numbers should be looked at with more scepticism.

e. In case the company has been doing the business for some time, we can also take a look at the historical revenue growth rate.

f. The assumed cost of operations should be througly scrutinised. Also it should be analysed that whether Fixed costs are reasonable like rent, salaries etc. As the business scales, has the required increased in fixed costs etc has it been accounted for.

g. It should be ensured that a buffer is kept for all the costs.

After this, the Investor should ideally do a scenerio analysis and divide the possible situations into best case, Most likely case and worst case. Accordingly once he does NPV analysis basis same, he can take a decision.

Also the rate of interest used to do the NPV should be representative of the riskiness of the underlying business. A more risky business should be discounted at higher IRR.