The higher the quality of the information in the first place, the more accurate your NPV calculations will be. Another way to deal with uncertainty is to make conservative estimates. A project that only has a positive NPV under ideal scenarios is not generally a worthwhile project. The scenarios upon which the decision is made should be less-than-ideal case scenarios. Conservative estimates of future cash flows should be used, as should a high hurdle rate. This should be related to the market, not simply be plucked from the air, or generated strictly on the basis of internal considerations. By planning for a poor scenario, only the projects with the highest likelihood of success will be undertaken. Therefore, if adverse conditions occur, the project still has a good chance to deliver a positive net present value.

In addition, the additional costs associated with adverse conditions should be considered and built into the projections. Risk management, contingency planning and disaster recovery should all be included in the cash flow analysis, weighted to reflect the risk of those funds needing to be spent. The risks must be fully analyzed for the impact and the odds of that impact being incurred.

The company should also safeguard against any negative conditions that it can reasonably expect. For example, the odds of a negative circumstance occurring might be low, but the damage done if it does occur can be high. In a case like...

Many negative externalities can not be controlled, but the damages stemming from them can be contained. Proper structuring of a transaction can hedge against adverse inflationary impacts on cash flows but matching inflows and outflows, for example.
Additionally, some flexibility should be built into the parameters used to make the decision in the first place. All of the information used can change overnight, so there should be some flexibility. The NPV should be stress-tested for changes in key variables, and weighed against the odds of those changes being manifested.

In this way, the company will get a better sense of the risks associated with the project. Assumptions should not be taken as fixed, they should always be evaluated on the basis of a range of likely outcomes.

By taking care in the formulation of cash flow projections, being conservative, and building in safeguards against adverse outcomes, a firm can strengthen its capital investment decision-making process.

Works Cited

No author. (1997). The Top 10 Things to Consider When Making a Capital Budgeting or Investment Decision. Coachville. Retrieved July 8, 2008 at http://www.topten.org/content/tt.AI19.htm

McCracken, Mark. (2005). Capital Budgeting. Teach Me Finance. Retrieved July 8, 2008 at http://www.teachmefinance.com/capitalbudgeting.html