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How do you know if a person is making unbiased estimates of Flip the argument around for another perspectiveSelected quiz questions from the Chapter 11 of the textbookChapter 11 Review QuestionsChapter 11 Practice Questions1 Chapter 11 – Where do Positive NPV Projects come from? (Capital Budgeting and Economics) Skip section 11.3 This chapter is concerned with answering the question: Where do positive NPV projects come from? In a competitive world, positive NPV projects should be difficult to find. Therefore, you should carefully evaluate projects that purport to produce a positive NPV. We focus on using our "economic intuition" in order to critically evaluate the assumptions used in calculating the project NPV. In particular we will: 1) Understand why (and when) we should trust market values. 2) Understand when it is likely we might earn "positive economic rents," and why, in general, they should not be expected. ****************************************************************************** In order to determine a project’s NPV, we need to determine the initial investment, expected future cash flows, and the discount rate(s). Estimation errors are unavoidable. For example, consider “Project A” (from the Chapter 7 notes) Time 0 cash flow (initial investment) = -$100 Project A time one expected cash flow calculation (from Chapter 7 notes): Boom economy cash flow = $155, probability = 20% Normal economy cash flow = $135, probability = 60% Recession economy cash flow = $40, probability = 20% Expected time one cash flow = $120 Beta = 1.80887 Discount rate = 20.1945% NPV = -$100 + $120 / 1.201945 = -$0.1618 Based on the project NPV, the project is rejected. Now, consider the estimation error Assume that the economy for the next year ends up being a ‘booming’ economy. So the project’s time 1 cash flow would have been $155. In retrospect, the project should have been accepted. However, based on the information available at time 0, the project was correctly rejected. In general, the expected cash flows that you calculate for an individual project are likely to be an overestimate or an underestimate of actual project cash flows. In the previous example, the actual cash flow would have been higher than the expected cash flow. However, over time and over many projects, overestimates from some projects should cancel out underestimates with other projects. Therefore, these estimation errors are diversified away to a certain extent. Even though you can’t estimate with 100% accuracy, the estimates of the expected future cash flows need to be unbiased.2 That is, actual cash flows should, on average, be equal to the expected cash flow. In the same way, you need to make an unbiased estimate of the discount rate. How do you know if a person is making unbiased estimates of future cash flows? If you make unbiased estimates of future cash flows, then these unbiased estimates should, on average, be equal to actual future cash flows (assuming you have enough observations across many projects and many years). Evidence of unbiased estimates of future cash flows – refer back to Project A and ignore inflation. Over a 100-year period of time, you would expect to see (roughly): 20 booming years with a $155 cash flow 60 normal years with a $135 cash flow 20 recession years with a $40 cash flow Total cash flows for 100 projects = $12,000 Average per project = $120 Example of biased estimates of future cash flows – an overly optimistic manager makes the following estimates for the cash flows in the three different types of economies. (Another possible error for the optimistic manager would have been to overestimate the probability of a booming economy.) Boom economy cash flow = $160 Normal economy cash flow = $140 Recession economy cash flow = $45 Effects on the NPV calculation for Project A: Using the unbiased estimates of economy probabilities Using the biased estimates of economy probabilities Expected cash flow $120 Beta 1.80887 Discount rate 20.1945% NPV -$0.1618 Only over time (and many projects) will we be able to determine that the manager is making biased estimates. Problems associated with making a biased estimate. No problem exists if there is no change in project selection due to the bias. A bias towards overestimating expected cash flows (or underestimating the discount rate) will make a good project look great. (Project is still accepted.) A bias towards underestimating expected cash flows (or overestimating the discount rate) will make a bad project look horrible. (Project is still rejected.) Problems occur in the following two circumstances: A bias towards overestimating expected cash flows (or underestimating the discount rate) can make a bad project look good. (Negative NPV project accepted.) This problem is compounded if a manager has an incentive to overestimate cash flows (or underestimate the discount rate). When would a manager have the incentive to do this?3 A bias towards underestimating expected cash flows (or overestimating the discount rate) can make a good project look bad. (Positive NPV project rejected.) This problem is compounded if a manager has an incentive to underestimate cash flows (or overestimate the discount rate). When would a manager have the incentive to do this? How do you prevent (or minimize) forecast errors? 1) Use market values. In other words, use the information that is available from the current market value (as established by investors that buy and sell the asset in question) in your analysis of the project. To use this approach, you need current market values from an asset that trades in an active and competitive market. Why do we want to use market values? If you try to estimate expected future cash flows (and discount rates) for an asset that trades in an active and competitive market, you might let your optimistic (or pessimistic) estimates bias your NPV calculations. This could cause you to accept a bad project (or reject a good project). We are assuming that the current market value established by numerous investors is a more reliable estimate of the asset’s true value than your own estimate. An example – You plan to invest in ABC stock and sell in one year. ABC stock does not currently pay dividends (and will not for the next several years). Assume the financial market where ABC stock trades is perfect, efficient, and in equilibrium. • Current stock


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TTU FIN 3322 - Positive NPV Projects

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