Create Better Forecasts, Not Ad Hoc Risk Premiums  61
Using scenarios has several advantages:
• It provides decision makers with more information. Rather than look-
ing at a project with a single-point estimate of expected value (say, $100 
million), decision makers know that there is a 20 percent chance that 
the project’s value is –$20 million and an 80 percent chance it is $120 
million. Making implicit risk assumptions explicit encourages dialogue 
about the risk of the project.
• It encourages managers to develop strategies to mitigate specific risks, 
because it explicitly highlights the impact of failure or less than com-
plete success. For example, executives might build more flexibility into 
a project by providing options for stepwise investments—scaling up in 
case of success and scaling down in case of failure. Creating such op-
tions can significantly increase the value of projects.
• It acknowledges the full range of possible outcomes. When project ad-
vocates submit a single scenario, they need it to reflect enough upside to 
secure approval but also be realistic enough that they can commit to its 
performance targets. These requirements often produce a poor compro-
mise. If advocates present multiple scenarios, they can show a project’s 
full upside potential and realistic project targets they can truly commit 
to while also fully disclosing a project’s potential downside risk.
Managers applying the scenario approach should be wary of overly sim-
plistic assumptions—say, a 10 percent increase or decrease to the cash flows. A 
good scenario analysis will often lead to a highly successful case that is many 
multiples of the typical base case. It will often also include a scenario with a 
negative value. In addition, there may not be a traditional base case. For many 
projects, there is only big success or failure, with low likelihood that a project 
will just barely earn more than the cost of capital.
Consider an extreme example. Project A requires an up-front investment 
of $2,000. If everything goes well with the project, the company earns $1,000 
per year forever. If not, the company gets zero. (Such all-or-nothing projects 
are not unusual.) To value project A, finance theory directs you to discount the 
expected cash flow at the cost of capital. But what is the expected cash flow in 
this case? If there is a 60 percent chance of everything going well, the expected 
cash flows would be $600 per year. At a 10 percent cost of capital, the project 
would be worth $6,000 once completed. Subtracting the $2,000 investment, the 
net value of the project before the investment is made is $4,000.
But the project will never generate $600 per year. It will generate annual cash 
flows of either $1,000 or zero. That means the present value of the discounted 
cash flows will be either $10,000 or nothing, making the project net of the initial 
investment worth either $8,000 or –$2,000. The probability of it being worth the 
expected value of $4,000 (that is, $6,000 less the investment) is zero. Rather than