Chapter 11, Problem 5PS

Biased forecasts Look back to the cash flows for projects F and G in Section 5-3. The cost of capital was assumed to be 10%. Assume that the forecasted cash flows for projects of this type are overstated by 8% on average. That is, the forecast for each cash flow from each project should be reduced by 8%. But a lazy financial manager, unwilling to take the time to argue with the projects’ sponsors, instructs them to use a discount rate of 18%.

1. a. What are the projects’ true NPVs?
2. b. What are the NPVs at the 18% discount rate?
3. c. Are there any circumstances in which the 18% discount rate would give the correct NPVs? (Hint: Could upward bias be more severe for more-distant cash flows?)