Accuracy of NPV Calculations Accuracy of Net

Accuracy of NPV Calculations

Accuracy of Net Present Value (NPV) Calculations

The accuracy and validity of Net Present Value (NPV) calculations has often led financial professionals to combine this measure of financial performance with others to gain greater insights into the strategic implications of decisions on projects. The fact that NPV alone cannot capture the variability of costs ands assumes linearity of costs and cash flows (Auguston, 1992). The best uses of NPV analysis are predicated on historical data where the linearity and predictive accuracy of cash flows can be achieved (Brush, 2003). Where there is a very high level of uncertainty in the financial figures or the broader business model, NPV figures are often inaccurate and only useful for showing directional, not precise, changes in the direction of investments (Phelan, 1997). With these foundational points of NPV in mind, the three businesses of a brand new retail startup, pharmaceutical company introducing a new drug, and a company with a successful product in Chile trying to introduce it into the U.S.A. are analyzed.

Accuracy of NPV Calculation Analysis

In assessing the accuracy of the three businesses, the underlying sources of cash flow projection and history need to be considered first. This, in addition to the structure of the business models and the ability of the founders and/or managers of the enterprise to accurately and completely control and predict costs. The longevity of the specific business model and its track record also must be taken into account, in addition to just hwo well understood the market dynamics are of the business itself (Auguston, 1992), The greater the level of uncertainty over a given product line or business model the less accurate NPV estimates will be (Phelan, 1997).

Starting with the brand new retail start-up, there will be significant costs associated with this business, and even greater costs of marketing and advertising to build its identity. It is unclear if the business will even be successful given how competitive retailing is and how quickly product lifecycles, pricing and tastes change. All of these factors can be derived from industry estimates and a stable NPV foundation can be defined., The lack of insight into the cash flow analysis however would make any estimates suspect. This will not be the most accurate prediction as a result. The second, creating a new drug with a pharmaceutical company, is also going to be extremely hard to get a reliable NPV figure on as drugs by their nature are highly regulated and costs over time will be nearly impossible to predict. There is also the uncertainty over market timing given the heavy regulation on drugs, and how that timing impacts consumer demand as well. Using more of a constraint-based model that includes linear programming to define pricing would be a better approach (Phelan, 1997). The third choice is for a company with a successful product in Chile trying to introduce it into the U.S.A. is analyzed. This would yield the most accurate NPV analysis as the costs of production, their trending over time, and the costs of marketing and selling would be readily known. There is also a defined market segment and insight into how and which marketing activities impact sales. Due to all of these factors, this third strategy will yield the most accurate NPV analysis.