Question

Explain the importance of understanding that cash flow forecasts in an NPV analysis are expected values.

Answer 1

When a project is being evaluated using NPV analysis various assumptions are being made as to the forecasting of cash flows. Assumptions realte to the cost incurred including material, personnel, rate of return required etc. It also includes the revenue gained which entails forecasting for sales, seasonality of revenues. W ehave to look at training costs for personnels and other contingencies that may arise. Having said all that, any project analysis used various combinations to arrive at cash flows. These cash flows are expected and in no way are guranteed. hence when evaluatinga project we shall take it into account. If volatility of cash flows is higher or if the cash flows are harder to predict then one may use a higher discount rate to incorporate for the risk. If we take cash flows for granted we may end up choosing projects that decrease the vaue of the firm.