20. Jon is conducting a capital budgeting analysis using NPV for a major expansi
ID: 2754722 • Letter: 2
Question
20. Jon is conducting a capital budgeting analysis using NPV for a major expansion of his
company. He is concerned because there is a lot of uncertainty about what the market conditions will be for his product the next few years. Jon has decided to decrease all of his revenue estimates because of the high risk of a bad outcome. Is this the correct way to handle uncertainty in an NPV analysis?
(a) No, because uncertainty about estimates is not important to capital budgeting decisions
(b) Yes, NPV analysis requires the use of cash flows adjusted downward for risk
(c) Only if Jon decreases his estimates to worst case scenarios
(d) None of the above is correct
why choose D?
Explanation / Answer
Traditional valuation techniques often fail to capture or adequately quantify the value created by technology initiatives or uncertainty in market conditions
In the prasent situation we have provided that,
Jon is conducting a capital budgeting analysis using NPV for a major expansion of his company
He is concerned because there is a lot of uncertainty about what the market conditions will be for his product the next few years
Jon has decided to decrease all of his revenue estimates because of the high risk of a bad outcome.
Is this the correct way to handle uncertainty in an NPV analysis =(d) None of the above is correct
why choose D?
Answer : The root of the problem is that static valuation methods tend to undervalue investments made under uncertainty.
There are other technique used to deal with uncertainity in NPV
Capital budgeting Techniques under uncertainty
1 Statistical Techniques for Risk Analysis
(a) Probability Assignment
(b) Expected Net Present Value
(c) Standard Deviation
(d) Coefficient of Variation
(e) Probability Distribution Approach
(f) Normal Probability Distribution
2 Conventional Techniques for Risk Analysis
3 Other Risk Analysis Techniques : Which includes the following
(a) Sensitivity Analysis
(b) Scenario Analysis
(c) Break Even Analysis
(d) Simulation Analysis
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