In Practice Estimating Expected Revenues and Cash flows

How do we estimate a project's expected revenues and expenses? The key word in this question is "estimate". No one, no matter what his or her skill at forecasting and degree of preparation, can forecast with certainty how a project will do. There are generally three ways in which we can make these forecasts:

a. Experience and History: The process of estimating project revenues and expenses is simplest for firms that consider the same kind of projects repeatedly. These firms can use their experience from similar projects that are already in operation to estimate expected values for new projects. Disney, for instance, can use its experiences with its theme parks in the United States, Tokyo Disney and Euro Disney in making its estimates for Disney Bangkok.

b. Market Testing: If the project being assessed is different from the firm's existing business, we may need a preliminary assessment of the market before actually investing in the project. In a market survey, potential customers are asked about the product or service being considered, to gauge the interest they would have in acquiring it. The results usually are qualitative and indicate whether the interest is strong or weak, allowing the firm to then decide whether to use optimistic forecasts for revenues (if the interest is strong) or pessimistic forecasts (if the interest is weak). Companies that need more information will often test market the concept on smaller markets, before introducing it on a larger scale. Test marketing not only allows firms to test out the product or service directly, but also yields far more detailed information about the potential size of the market.

c. Scenario Analysis: There are cases in which a firm is considering introducing a product to a market it knows well, but there is considerable uncertainty introduced by external factors that the firm cannot control. In such cases, a firm may decide to consider different scenarios, and the revenues and expenses on the project under each scenario. While the concept is a simple one, it has four critical components. The first is the determination of which factors the scenarios will be built around. The second component is determining the number of scenarios to analyze for each factor. While more scenarios may be more realistic than fewer, it becomes more difficult to collect information and differentiate between the scenarios in terms of project revenues. The third component is the estimation of project revenues and expenses under each scenario. The final component is the assignment of probabilities to each scenario. While we have laid out three ways of estimating revenues and expenses for projects, none of these approaches yields perfect estimates. While some project risk may come from estimation error, a large portion of risk comes from real uncertainty about the future. Improving estimation techniques, using more market testing and doing scenario analysis may reduce estimation error but cannot eliminate real uncertainty. This is why we incorporate a risk premium into the discount rate.

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