Challenges To NPV Production

Challenges to NPV production - discussion points taken from the CIMA MCS model answers
Key point – make sure that your answer applies to the specific scenario. If you answer purely in
generic terms you will not gain as many marks.
Project investment value
Is the investment value already determined? If not, there may be challenges in determining its value.
Purchasing an asset for a project:
For acquisition of non-current assets – use price lists, info on similar assets acquired in the past. If
alterations will be needed (e.g. refurbish an acquired building), will need estimates for these costs.
Purchasing a business:
For acquisition of another business, has negotiation of price already started? If so, get best estimate
from the negotiating team. If not, look for recent values for similar acquired businesses if available.
Other investments:
The scale of the project may need to be determined before an appropriate cost can be predicted,
e.g. for an advertising project.
Revenues
Revenues generated from a purchased asset:
Sales volumes from new products or existing products in new markets will be more difficult to
predict than for growth within an existing market. May need market research to be undertaken to
obtain realistic forecasts.
Similarly with sales prices. Look for prices of similar goods/services to base forecasts on.
The level of competition will have an effect on achievable volumes and prices. The project being
undertaken, if innovative, may attract competitors into the market. Scenario analysis or stress
testing may help to understand the consequences of this for a project.
Is the benefit of the project in terms of saved cost rather than generated revenues? This may be
harder to quantify.
If there is a potential range of volumes and/or prices then techniques such as sensitivity analysis or
expected values may need to be used to understand the risk levels faced
Could there be knock on effects to sales of the company’s other products / services? These would
have to be incorporated into the NPV as an opportunity cost.
Revenues generated from an acquired business:
Are there existing revenue forecasts produced by the business being acquired that could be used?
There may be difficulty in accessing these in the early stages of negotiation. May need to estimate
based on published financial statements figures.
Need to determine the effect of any planned changes post-acquisition, e.g.:

Products / markets that will be launched / targeted for growth / discontinued.
Existing contracts of the acquired business that may be put into default by a takeover.
Operating cost cash flows
Costs of operating an acquired asset:
Does the company have experience of operating such assets? If so, there may be a basis for
forecasting the cash flows. If not, research will be needed as to likely costs.
Will changes need to be made to existing operations / systems / skill levels to undertake the project?
Will the asset need replacing before the project is complete?
Do new materials need to be sourced? If so, is there an understanding of the volatility of prices for
them?
Will there be an impact on inventory management, perhaps even needing to increase warehousing
capacity?
Costs of operating an acquired business:
Are there existing operational cost forecasts that could be used? E.g. if acquiring a business, could
their forecasts be used? May be difficulty in accessing these in early stages of negotiation.
There will be particular difficulty if the operations of the acquired business are different to the
purchaser’s operations. E.g. if a retailer acquires a manufacturer, they will not have experience in
managing or forecasting manufacturing costs.
Need to determine the effect of any planned changes post-acquisition, e.g.:
Redundancy / relocation / reorganisation / adverse publicity / training costs
Synergies gained
Costs of operating in a different country (if relevant) – taxes, legal aspects, different wages and
salary costs
Economic factors
Factors such as interest rates, inflation rates, government taxation policies, etc. will all have an
impact on the NPV and may be difficult to predict.
Cost of capital
This is not readily available for companies whose shares are not traded on a stock market.
For companies with quoted shares, a cost of capital may be determined, but this may not be
relevant for the project NPV if the project represents a change in risk for the shareholders.
Timescale
Easier if the assets purchased have a specified useful life.
Challenges for projects with no obvious end date, such as a business acquisition. May need to
forecast cash flows into perpetuity, with appropriate assumptions made as to the level of ongoing
revenues and costs.
Overall
Investment appraisals are made up of estimated future values. These estimates may be difficult to
determine and make the outcome of the investment risky. The project may be rejected if it is found
that these estimates are not accurate.
Decisions may need to be made about the scale of the project, ambitions for growth, whether to run
an acquired company differently, etc. These will affect the revenues and costs.
An extra challenge arises if the investment involves some form of foreign currency, in that
movements in exchange rates will affect cash values when translated into the home currency.

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Challenges to NPV production - discussion points taken from the CIMA MCS model answers

Project investment value

Purchasing an asset for a project:

Revenues generated from a purchased asset:

Revenues generated from an acquired business:

Need to determine the effect of any planned changes post-acquisition, e.g.:

Operating cost cash flows

Costs of operating an acquired asset:

Will the asset need replacing before the project is complete?

Costs of operating an acquired business:

Need to determine the effect of any planned changes post-acquisition, e.g.:

Redundancy / relocation / reorganisation / adverse publicity / training costs

Easier if the assets purchased have a specified useful life.

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