Alan said:
The 'nature' of the calculations for an NPV (let's leave IRR for now),
are really quite simple.
....
It's the seemingly simple things that tend to cause the biggest problems
because they come as such a surprise. Start with a simple interest rate like
3.0%. That seems to be a simple number. Two problems: first, 0.03 is an
infinitely repeating *BINARY* fraction like 1/3 is an infinitely repeating
decimal fraction; two, the interest rate isn't used directly, 1 plus the
interest rate is.
Each later age requires the successively higher integer power of 1+r, so
even if the calculations were done in decimal you'd quickly arrive at a
point at which you can't retain the lowest order digits.
Time 1 1.03
Time 2 1.0609
Time 3 1.092727
Time 4 1.12550881
Time 5 1.1592740743
Time 6 1.194052296529
Time 7 1.22987386542487
Time 8 1.2667700813876161
Time 8 exceeds 15 decimal digits, so it can't and won't be representented
except as truncated or rounded in Excel.
Without wishing to be presumptious, I am guessing that you are
referring to the level of precision that can be held in a single cell
(15 significant figures if I recall correctly).
Got it in one.
If so, then I think that, in theory you are absolutely correct, but
that in a commercial environment, we rarely have the precision of
inputs / assumptions to warrant showing results to more than three or
four significant figures. I often wish it were otherwise!
You're confusing the imprecision of inputs/estimates of future cashflows
with the precision of NPV calculations based on those cashflows. I too work
in a commercial environment, but I don't glibly dismiss the benefits of
greater precision of calculations just because the inputs are flaky. I
employ standard sensitivity testing to check the reasonableness of results
by varying the cashflows stochastically. If my discount rate is a true cost
of capital estimate, it gives me a measure of uncertainty which I can
translate into variation of a cashflow around its assumed mean.
If I have misunderstood your post, please do clarify, as I am always
keen to improve!
Given the superficiality of comments such as "in a commercial environment,
we rarely have the precision of inputs / assumptions to warrant showing
results to more than three or four significant figures.", it's obvious you
don't see the point of distinguishing between what you display and what you
calculate. It's difficult to believe there's any hope you could improve.
Estimates of future cashflows are only that, estimates. You have a point
that there's no reason to estimate them to 9 significant digits. However,
the NPV calculation is different. There's no good reason to round your
discount factors. Note that if your nominal cashflows were displayed to only
3 significant digits and your discount factors rounded to only 4 decimal
places, then the product of these two sets of numbers have 7 significant
digits. If you then round these to 3 or 4 significant digits, you're
effectively eliminating the possibility of any meaningful NPV result less
than 1.0% or 0.1% of your largest individual cashflow. If you're going to do
that, why bother with pseudo-NPV calculations at all? Just sum up the
negative cashflows and calculate their dollar-weighted average payout date
and sum up the positive cashflows and calculate their dollar-weighted
average receipt date. Then calculate your pseudo-NPVs as
CumPosCFs/(1+r)^Avg Receipt Date - CumNegCFs/(1+r)^Avg Payout Date
The calculations are even simpler than your pseudo-NPV, and it's highly
likely the two would give the same accept/reject results except for those
cashflows in which sensitivity testing is necessary to decide for sure
whether the project represented by the cashflows makes sense or not.
