Question

At an office party, your colleague cites the example of DuPont's TEFLON to dismiss the value of capital budgeting because, as rumor has it, was a negative NPV project. As an avid practitioner of cutting-edge corporate financial analysis, what do you say to her?

Answer 1

The NPV analysis and the accept/reject decision depends on several assumptions and estimates such as :

• cost of capital
• projected cash flows
• constant growth rate after terminal point

The NPV is sensitive to each of these inputs, and a change in any of these can results in varying estimates of NPV.

Thus, any project should be analysed based on a NPV sensitivity analysis, and not on a single estimated NPV. NPV sensitivity analysis is where each input is changed to project a range of possible NPVs. Thus, the best-case, worst-case and the in-between cases can be analysed based on changes in the inputs. A probability can be assigned to each scenario, and thus the expected NPV can be estimated based on the probability distribution.

In the case of TEFLON, if it was a negative NPV project, the probability of TEFLON's success was likely to have been low. However, DuPont went ahead with the project. This shows that NPV analysis is not the sole criterion on which a project's accept/reject decision should be based. NPV is an important financial consideration because it shows whether a project creates value or not. However, the ultimate success of a project depends on several non-financial considerations, which are not captured in NPV analysis.

Therefore, NPV analysis must be done to understand the financial outcome of a project. However, it should not be the sole criterion for accepting or rejecting a project.