Primus Automotive Division

Analyzing the Project

When evaluating a capital budgeting project, financial managers should make the decision that maximizes NPV. As we have discussed, to compute the NPV for a project you need to estimate the incremental free cash flows and choose a discount rate. Given these inputs, the NPV calculation is relatively straightforward. The most difficult part of capital budgeting is deciding how to estimate the cash flows and cost of capital. These estimates are often subject to significant uncertainty. In this section, we look at methods that assess the importance of this uncertainty and identify the drivers of value in the project.

Sensitivity Analysis

An important capital budgeting tool for assessing the effect of uncertainty in forecasts is sensitivity analysis. Sensitivity analysis breaks the NPV calculation into its component assumptions and shows how the NPV varies as the underlying assumptions change. In this way, sensitivity analysis allows us to explore the effects of errors in our NPV estimates for a project. By conducting a sensitivity analysis, we learn which assumptions are the most important; we can then invest further resources and effort to refine these assumptions. Such an analysis also reveals which aspects of a project are most critical when we are actually managing the project. In fact, we have already performed a type of sensitivity analysis in Chapter 7when we constructed an NPV profile. By graphing the NPV of a project as a function of the discount rate, we are assessing the sensitivity of our NPV calculation to uncertainty about the correct cost of capital to use as a discount rate. In practice, financial managers explore the sensitivity of their NPV calculation to many more factors than just the discount rate. To illustrate, consider the assumptions underlying the calculation of HomeNet’s NPV in Example 8.5. There is likely to be significant uncertainty surrounding each revenue and cost assumption. In addition to the base case...