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You are at your desk at work when a co worker excitedly comes to your desk...

You are at your desk at work when a co worker excitedly comes to your desk and shows you the scenario analysis that he has just completed for a potential new project. All three scenarios show a positive NPV. He states, "we have to take this project!". What is your initial reaction regarding this new project. Do you believe the results of the scenario analysis?
What is the risk of assuming he is correct if he is wrong?
What is the risk of assuming he is wrong if he is correct?

business   economics   
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Answer #1

When the task showing positive NPV, this simply shows that the project can increase shareholder wealth. Nevertheless, NPV analysis is based upon numerous presumptions that may not hold true in a real-life scenario. The danger of presuming he is proper if he is wrong is using a discount rate which is too low. When using a low discount rate, NPV will show favorable compared to a higher discount rate. This might lead to the incorrect choice being made. If he is proper, then the threat is that the business does not have adequate capital to purchase the project (in the circumstance of tough and soft capital rationing) and hence the financial investment does not continue, and hence shareholder wealth is not increased. Hope this helps!

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