Introduction to Finance

Safety Margin 
Suppose an analyst tells you that the NPV of project Big is $100,000 
while a competing project, project Small, has an NPV of $60,000. From our earlier discussion, 
it would appear that you should select Big because of its larger NPV. But what if Big requires 
a $5 million investment while Small requires only a $600,000 investment? If the PV estimates 
14
John R. Graham and Campbell R. Harvey, “The Theory and Practice of Corporate Finance: Evidence from the 
Field,” 
Journal of Financial Economics
, 2001, vol. 60, no. 1, pp. 187–243. 
15
M. Stanley and S. Block, “A Survey of Multinational Capital Budgeting,” 
Financial Review
, (March 1984), 
pp. 36–54. 

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C H A PT E R 1 7 Capital Budgeting Analysis
of project Big’s cash fl ows are off by only 2 percent, the forecasted positive NPV becomes 
negative. The PV of Small’s cash fl ows can deviate from plan by 10 percent before the project 
turns into a loser.
Suppose, instead, the analyst tells you that Big’s IRR is 10.5 percent, Small’s IRR is 15 
percent, and the required return is 10.0 percent. Would you feel confi dent that Big is the more 
attractive project despite its higher NPV? Perhaps not, as a small change in cash fl ows could 
push Big’s IRR below 10 percent.
This rather contrived example illustrates why managers in the real world may prefer to use 
relative DCF measures, such as the IRR or the profi tability index. IRR and PI give the decision 
maker an intuitive feel for a project’s “safety margin.” The decision maker will sleep better 
at night after deciding to undertake a smaller project with a larger safety margin and reject a 
large project with a small safety margin. Most managers have seen reality defy forecasts, and 
they know that an inadequate safety margin can make taking big investment risks unwise. 
Post-project audits can give the fi rm a better perspective on the accuracy or inaccuracy of its 
cash fl ow forecasting techniques. This information can help improve management’s perspect-
ive on the safety cushion needed for a typical project.