*We assume a tax credit is created in our worst-case scenario.

*We assume a tax credit is created in our worst-case scenario.

What we learn is that under the worst scenario, the cash flow is still positive at $24,490. That's good news. The bad news is that the return is -14.4 percent in this case, and the NPV is -$111,719. Because the project costs $200,000, we stand to lose a little more than half of the original investment under the worst possible scenario. The best case offers an attractive 41 percent return.

The terms best case and worst case are very commonly used, and we will stick with them, but we should note they are somewhat misleading. The absolutely best thing that could happen would be something absurdly unlikely, such as launching a new diet soda and subsequently learning that our (patented) formulation also just happens to cure the common cold. Similarly, the true worst case would involve some incredibly remote possibility of total disaster. We're not claiming that these things don't happen; once in a while they do. Some products, such as personal computers, succeed beyond the wildest of expectations, and some, such as asbestos, turn out to be absolute catastrophes. Instead, our point is that in assessing the reasonableness of an NPV estimate, we need to stick to cases that are reasonably likely to occur.

Instead of best and worst, then, it is probably more accurate to use the words optimistic and pessimistic. In broad terms, if we were thinking about a reasonable range for,

Ross et al.: Fundamentals of Corporate Finance, Sixth Edition, Alternate Edition

IV. Capital Budgeting

11. Project Analysis and Evaluation

© The McGraw-Hill Companies, 2002

PART FOUR Capital Budgeting sensitivity analysis

Investigation of what happens to NPV when only one variable is changed.

A cash flow sensitivity analysis spreadsheet is available at ^tools/cfsens _ m.asp.

say, unit sales, then what we call the best case would correspond to something near the upper end of that range. The worst case would simply correspond to the lower end.

As we have mentioned, there is an unlimited number of different scenarios that we could examine. At a minimum, we might want to investigate two intermediate cases by going halfway between the base amounts and the extreme amounts. This would give us five scenarios in all, including the base case.

Beyond this point, it is hard to know when to stop. As we generate more and more possibilities, we run the risk of experiencing "paralysis of analysis." The difficulty is that no matter how many scenarios we run, all we can learn are possibilities, some good and some bad. Beyond that, we don't get any guidance as to what to do. Scenario analysis is thus useful in telling us what can happen and in helping us gauge the potential for disaster, but it does not tell us whether or not to take the project.

Project Management Made Easy

Project Management Made Easy

What you need to know about… Project Management Made Easy! Project management consists of more than just a large building project and can encompass small projects as well. No matter what the size of your project, you need to have some sort of project management. How you manage your project has everything to do with its outcome.

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