Summary And Conclusions

In this chapter, we looked at some ways of evaluating the results of a discounted cash flow analysis. We also touched on some of the problems that can come up in practice. We saw that:

1. Net present value estimates depend on projected future cash flows. If there are errors in those projections, then our estimated NPVs can be misleading. We called this possibility forecasting risk.

2. Scenario and sensitivity analysis are useful tools for identifying which variables are critical to the success of a project and where forecasting problems can do the most damage.

3. Break-even analysis in its various forms is a particularly common type of scenario analysis that is useful for identifying critical levels of sales.

4. Operating leverage is a key determinant of break-even levels. It reflects the degree to which a project or a firm is committed to fixed costs. The degree of operating leverage tells us the sensitivity of operating cash flow to changes in sales volume.

5. Projects usually have future managerial options associated with them. These options may be very important, but standard discounted cash flow analysis tends to ignore them.

6. Capital rationing occurs when apparently profitable projects cannot be funded. Standard discounted cash flow analysis is troublesome in this case because NPV is not necessarily the appropriate criterion anymore.

The most important thing to carry away from reading this chapter is that estimated NPVs or returns should not be taken at face value. They depend critically on projected cash flows. If there is room for significant disagreement about those projected cash flows, the results from the analysis have to be taken with a grain of salt.

Despite the problems we have discussed, discounted cash flow analysis is still the way of attacking problems, because it forces us to ask the right questions. What we have learned in this chapter is that knowing the questions to ask does not guarantee we will get all the answers.

0 0

Post a comment