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Lecture Notes 8
Applying Judgement in Net Present Value Analysis
GarbageIn, GarbageOut
• 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 “garbagein, garbageout.” 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 decisionmaking. 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 decisionmaking 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
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tinually on the lookout for possible profitable “market niches” on the demand side or “costsaving
opportunities” on the supply side.
• Having identified a possible positive NPV project, the next step involves making judgements
about the various components needed to perform a formal NPV analysis. It is best to be explicit
about the source for these judgements and to write the reasoning down – preferably in a way that
is capable of being discussed with a colleague, particularly a very skeptical and argumentative
colleague!
• After you have completed the NPV analysis it is important to critically examine the
results
. In
particular, if the analysis reveals a large positive NPV for the project, you should ask, and docu
ment, why this might be the case. In general, positive NPV projects are hard to find! Millions of
others are continually seeking projects with positive profits (
relative to
the competitive rate of
return as reflected in the discount rate – the “normal profits” discussed in economics correspond
to
zero
NPV projects). In a competitive market, barriers to entry are low and positive NPV
projects are likely to disappear rapidly.
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 Spring '06
 Bejan
 Net Present Value, analyst, NPV analysis, positive NPV projects, positive NPV

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