Question

Your firm is considering buying a truck to make deliveries. If they buy the less expensive truck, the expected NPV will be higher than if they buy the more expensive option, however, the risk of breakdowns disrupting sales was not considered in the estimation of the two truck alternatives’ NPVs. How should the added risk associated with the less expensive truck be incorporated into the estimation of its NPV? Explain.

Answer 1

There are two ways to handle this. Either the loss of cash flows due to disruptions in sales must be estimated and added to the cash flow analysis or the discount rate should be adjusted to a higher level.

The loss of sales due to the new project is cannibalization cost which must be taken into account if the losses can be reasonably extimated. So if there are going to be losses worth $5 million every year, the same must be deducted from the FCFF each year used for NPV compution. Alternatively the discount rate can be raised to account for the additional risk. This will reduce the present value of the cash flows and give a true picture of the NPV.