Sources of Value

The first line of defense against forecasting risk is simply to ask: "What is it about this investment that leads to a positive NPV?" We should be able to point to something specific as the source of value. For example, if the proposal under consideration involved a new product, then we might ask questions such as the following: Are we certain that our new product is significantly better than that of the competition? Can we truly manufacture at lower cost, or distribute more effectively, or identify undeveloped market niches, or gain control of a market?

These are just a few of the potential sources of value. There are many others. For example, in 2001, consumer products giant Unilever launched an advertising campaign for a new deodorant. This market is already pretty crowded, but Unilever believed it had an edge—the Dove brand name. In fact, Unilever had been leveraging the Dove name extensively, creating a wide variety of personal care products. In each case, Unilever's source of value was the widespread consumer perception of Dove as a premium product.

A key factor to keep in mind is the degree of competition in the market. It is a basic principle of economics that positive NPV investments will be rare in a highly competitive environment. Therefore, proposals that appear to show significant value in the face of stiff competition are particularly troublesome, and the likely reaction of the competition to any innovations must be closely examined.

It is also necessary to think about potential competition. For example, in the late 1990s, the United States was facing a critical shortage of wallboard, the gypsum-based product used for interior walls in homes and offices. The biggest producer of wallboard (also known as drywall), USG Corporation, spent hundreds of millions to modernize its facilities and ramp up output to take advantage of what appeared to be an excellent profit opportunity. There was only one problem. Other producers did the same thing. Supply soared and prices fell from $166 per 1,000 square feet to just $94 in 2000, forcing USG to cut back and eliminate some of its manufacturing capacity.

The point to remember is that positive NPV investments are probably not all that common, and the number of positive NPV projects is almost certainly limited for any given firm. If we can't articulate some sound economic basis for thinking ahead of time that we have found something special, then the conclusion that our project has a positive NPV should be viewed with some suspicion.

Ross et al.: Fundamentals IV. Capital Budgeting 11. Project Analysis and of Corporate Finance, Sixth Evaluation

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