Ross et al.: Fundamentals
of Corporate Finance, Sixth
Edition, Alternate EditionIV. Capital Budgeting 11. Project Analysis and
Evaluation(^380) © The McGraw−Hill
Companies, 2002
in identifying areas where potential errors exist and where they might be especially
damaging. In one form or another, we will be trying to assess the economic “reason-
ableness” of our estimates. We will also be wondering how much damage will be done
by errors in those estimates.
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 spe-
cific 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 manufac-
ture 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 ex-
ample, 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 ex-
tensively, 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 competi-
tive environment. Therefore, proposals that appear to show significant value in the face
of stiff competition are particularly troublesome, and the likely reaction of the competi-
tion to any innovations must be closely examined.
It is also necessary to think about potentialcompetition. 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, forc-
ing 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 posi-
tive NPV should be viewed with some suspicion.
SCENARIO AND OTHER WHAT-IF ANALYSES
Our basic approach to evaluating cash flow and NPV estimates involves asking what-
if questions. Accordingly, we discuss some organized ways of going about a what-if
CONCEPT QUESTIONS
11.1a What is forecasting risk? Why is it a concern for the financial manager?
11.1bWhat are some potential sources of value in a new project?
CHAPTER 11 Project Analysis and Evaluation 351