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Lecture Notes 8
Applying Judgement in Net Present Value Analysis
Garbage-In, Garbage-Out
• We have discussed using NPV analysis to decide whether or not it is sensible to invest in a par-
ticular project. Applying NPV analysis requires us to make judgments about factors associated
with the project such as:
i. revenues,
ii. expenses,
iii. depreciation tax shields,
iv. true economic lives of plant and equipment, and
v. the appropriate discount rate.
• Once we have made decisions about these factors, the analysis gives us a precise formula for de-
ciding whether or not we should proceed with the project. We should be careful, however, not to
confuse the precision of the
method
for the precision of the
result
. The confidence we should have
in a decision to proceed with a project, or forgo the investment opportunity, depends critically on
the confidence we have in the assumptions that have been incorporated into the analysis.
• In computer science, people talk about situations like this as “garbage-in, garbage-out.” A com-
puter, like our NPV procedure for project analysis, will give us “garbage” (wrong or, at best, mis-
leading) output if there are errors in the information that is input as data. This is not a criticism of
using computers, or computational algorithms, as an aid in decision-making. It is a reason, how-
ever, for not relying
blindly
on the results produced by such methods.
Judging the results of an analysis
• NPV analysis is best used as a crucial component of an iterative decision-making procedure.
• In the first instance,
potential
positive NPV projects more than likely have to be identified by a
procedure that is hard to quantify or even systematize. In general, however, you need to be con-