Getting Started

We are investigating a new project. Naturally, the first thing we do is estimate NPV based on our projected cash flows. We will call this initial set of projections the base case. Now, however, we recognize the possibility of error in these cash flow projections. After completing the base case, we thus wish to investigate the impact of different assumptions about the future on our estimates.

One way to organize this investigation is to put an upper and lower bound on the various components of the project. For example, suppose we forecast sales at 100 units per year. We know this estimate may be high or low, but we are relatively certain it is not off by more than 10 units in either direction. We thus pick a lower bound of 90 and an upper bound of 110. We go on to assign such bounds to any other cash flow components we are unsure about.

When we pick these upper and lower bounds, we are not ruling out the possibility that the actual values could be outside this range. What we are saying, again loosely speaking, is that it is unlikely that the true average (as opposed to our estimated average) of the possible values is outside this range.

An example is useful to illustrate the idea here. The project under consideration costs $200,000, has a five-year life, and has no salvage value. Depreciation is straight-line to zero. The required return is 12 percent, and the tax rate is 34 percent. In addition, we have compiled the following information:

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