CHAPTER TEN A PROJECT IS NOT A BLACK BOX A BLACK BOX is something that we accept and use but do not understand. For most of us a computer is a black box. We may know what it is supposed to do, but we do not understand how it works and, if something breaks, we cannot fix it. | Brealey-Meyers III. Practical Problems in 10. A Project is Not a Black The McGraw-Hill Principles of Corporate Capital Budgeting Box Companies 2003 Finance Seventh Edition CHAPTER TEN Brealey-Meyers Principles of Corporate Finance Seventh Edition III. Practical Problems in Capital Budgeting 10. A Project is Not a Black Box The McGraw-Hill Companies 2003 A BLACK BOX is something that we accept and use but do not understand. For most of us a computer is a black box. We may know what it is supposed to do but we do not understand how it works and if something breaks we cannot fix it. We have been treating capital projects as black boxes. In other words we have talked as if managers are handed unbiased cash-flow forecasts and their only task is to assess risk choose the right discount rate and crank out net present value. Actual financial managers won t rest until they understand what makes the project tick and what could go wrong with it. Remember Murphy s law If anything can go wrong it will and O Reilly s corollary at the worst possible time. Even if the project s risk is wholly diversifiable you still need to understand why the venture could fail. Once you know that you can decide whether it is worth trying to resolve the uncertainty. Maybe further expenditure on market research would clear up those doubts about acceptance by consumers maybe another drill hole would give you a better idea of the size of the ore body and maybe some further work on the test bed would confirm the durability of those welds. If the project really has a negative NPV the sooner you can identify it the better. And even if you decide that it is worth going ahead on the basis of present information you do not want to be caught by surprise if things subsequently go wrong. You want to know the danger signals and the actions you might take. We will show you how to use sensitivity analysis break-even analysis and Monte Carlo simulation to identify crucial assumptions and to explore what can go .
