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 do this:

• Increase the discount rate used for NPV calculation: Discount rate is supposed to be a measure of riskiness of the cash flows. Discount rate is assumed to incorporate all the risks associated with the cash flows being generated. If the older trucks are likely to have more disruption or downtime, hence the cash flows from these are not that stable. Cash flows are volatile and hence they should be discounted at a higher discount rate.
• The other way to take care of this is to adjust the cash flows to reflect higher downtime or opportunity lost. The potential revenues will suffer due to frequent breakdowns and disruptions. Further the maintenance expenses will also be more in case of older trucks.

Thus by one or both of these ways, the added risk associated with the less expensive truck can be incorporated into the estimation of its NPV