Principles of Finance
One of the most widely used financial evaluation techniques is the Net Present Value measurement. The NPV is the present value of all the cash inflows and outflows estimated for the project arising starting from the present till the future. Since NPV deals with future cash flows converting them into present values, there are three main assumptions that are laid in calculating the NPV of a project. These assumptions are: • The cash flow amounts are exact. • The timings of the cash flows occur at the year end (the initial investment occurring at the beginning of the year).
• The probability of occurrence of each cash flow is cer...
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...tain (Ross, Westerfield, & Jaffe, 2008). The application of these assumptions without any care often leads to significant errors. Thus, it is essential to exercise certain measures to minimize the errors while applying these assumptions in the calculation of NPV so. It should be understood that the future is unpredictable, yet the NPV is applied with future cash flows estimated to be in different years taken to be exact.
Since the assumption cannot be eradicated, the counter-measure then is to use forecasting techniques and estimate the cash flow to the highest degree of accuracy. Sometimes probabilities play their role in influencing the value of the future cash flow. A weighted average method to achieve the estimated cash flow will result in a more realistic estimated future cash flow than rough guessing or any other surmise based on intuition. Though intuition may be correct at times, the probabilistic approach is the safest to use in minimizing the potential error by using an off cash flow value for the NPV.
The timings of the cash flow may occur anywhere even during the year in the real scenario. The best adjustment to minimize the loss arising out of this assumption can be done by adjusting the value of the cash flow by the interest rate (discount rate) so that the year end cash flow is equal to the cash flow arising in between the year. Another way of countering this problem is to take the average cash flow of two in-between periods and then assume it to be the cash flow at the year end in between the two half-years. Example:
2007 June: the estimated cash flow is $150 2008 May: the estimated cash flow is $1000 The estimated cash flow is: $ 575 (average of $1100 and $150) at the end of year 2007 (December). Though this adjustment may still not yield very accurate results the error will be beset to the maximum possible extent. The aim at the end of the day is that since the NPV is working with future values, it cannot be wholly accurate, measures should be such that they ensure that the NPV is as accurate as possible. The probability of occurrence of a cash flow is assumed to be certain i.
e. 1 for the NPV calculation. This is a very far-fetched assumption in terms of the variance that one may often see in estimated and actual incomes/costs, etc. When accountants plan budgets, they also assume that cash flows will occur with certainty. However, the use of a probability weight is often the key to eliminating errors. Often there are more than outcomes possible for a future cash flow.
For example: An oil company is estimating that if it gets a new contract (the probability of which is 0. 6) they will earn $100,000 revenue after 2 years. But if they do not get the contract, they will earn a revenue from other activities of $20,000. An expected value computed from the above probabilities suggests that the estimated cash flow is $68,000. Rather than taking either of $100,000 or $20,000 as the cash flow, $68,000 is taken – since this is a more accurate measure of a certain cash flow than either of the values. In conclusion, it is often necessary to weigh your odds and make necessary estimations when computing NPV.
However, overcoming the errors that may arise due to the assumptions requires intelligent analysis of the situation and usage of probabilistic models. Since certainty is a subjective matter when speaking about the future, the aim should be to be as accurate as possible in estimating the Net Present Value of a project. This, as described above, is achievable through the use of probability weightage, usage of Expected values of different outcomes that may occur for the same period and