Introduction to Finance

Managerial Flexibility and Options 
The popularity of NPV and DCF techniques 
also suff ers because they are diffi
cult to apply to projects that entail future investment oppor-
tunities or options. These techniques do not suit some situations in which managerial fl exibility 
can be valuable. For example, if a project involves a joint venture, an R&D eff ort, or a move 
into new markets, management may face several choices once the project is underway. After 
seeing the initial results, management may decide to continue the project as planned, to expand 
its scope in the face of success, to decrease the scope of the project, to defer further investment, 
or to abandon the project. These kinds of decisions can improve a project’s potential for upside 
return while limiting its loss potential. Such fl exibility is hard to model in terms of cash fl ows 
and discount rates. Payback periods, for example, may be useful as a means to give managers 
a general feel for how much time a project needs to at least break even and recover its costs.
Confl icts may arise when a fi rm wants to coordinate strategy analysis and shareholder 
value analysis. The numbers on the analyst’s spreadsheet may fail to justify the actions the cor-
porate planner strongly feels will lead to competitive advantage and future investment oppor-
tunities. But strategic analysis and fi nancial analysis, if properly applied, are compatible. More 
often than not, confl icts between these two sets of tools result from inadequate estimates of 
the cash fl ows from implementing a strategy. Unless the cash fl ows that result from a strategic 
plan are estimated correctly, good projects can be rejected on the basis of inaccurate NPVs or 
IRRs. The process of estimating a project’s cash fl ows is the next topic of the section and is 
examined in more depth in this chapter’s Learning Extension.
17.9
Estimating Project Cash Flows
This section reviews methods of developing cash fl ow forecasts based on input from engin-
eering, economic, and market analyses, as well as from examination of the fi rm’s competitive 
advantages.
Isolating Project Cash Flows 
To estimate the cash fl ows of a proposed capital budgeting project, the project must be viewed 
separately from the rest of the fi rm. This