448_08Judgement - Lecture Notes 8 Applying Judgement in Net...

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65 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-
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66 tinually on the lookout for possible profitable “market niches” on the demand side or “cost-saving 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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448_08Judgement - Lecture Notes 8 Applying Judgement in Net...

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