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Unformatted text preview: should invest in projects that are worth more than they costs. Investment
projects are only worth more than they cost when the net present value is positive. The
net present value of a project is calculated by discounting future cash flows, which are
forecasted. Thus, projects may appear to have positive NPV because of errors in the
forecasting. To evaluate the influence of forecasting errors on the estimated net
present value of the projects several tools exists:
- Sensitivity analysis
– Analysis of the effect on estimated NPV when a underlying assumption
changes, e.g. market size, market share or opportunity cost of capital.
– Sensitivity analysis uncovers how sensitive NPV is to changes in key variables. – Scenario analysis
– Analyses the impact on NPV under a particular combination of assumptions.
Scenario analysis is particular helpful if variables are interrelated, e.g. if the
economy enters a recession due to high oil prices, both the firms cost
structure, the demand for the product and the inflation might change. Thus,
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- Spring '12