This chapter gives some basic and very valuable lessons in the economics of competition. Modern market economies have intense competition in nearly all industries. Very few firms can expect to earn economic profits or have positive NPV investments unless they have a sustainable comparative advantage in the business they are engaged in. No matter how much we know about the theory of making capital budgeting decisions, we will end up making bad decisions if our forecasts of cash flows turn out badly. This chapter shows you how you can ensure that these forecasts are as good as possible.

The first section of the chapter describes how some difficult forecasting problems may be avoided by making use of available market information. The second section focuses on the market in which the firm operates. Firms do not get positive NPV projects without there being some reason for it. A positive NPV can arise only if the firm has some comparative advantage or what the business strategists call competitive advantage. It is important to understand just the nature of such an advantage. What is it that enables the firm and not some other company to exploit the opportunity provided by the project? If you can answer this question satisfactorily, you probably have understood the project and the source of the positive NPV.

These ideas are elaborated using a small case study (Marvin Enterprises). Your company can expect a positive NPV from a project if it has competitive advantage in one or more aspects of the project. However, it is good to remember that other firms are not going to be idle and will whittle away your competitive advantage over time. In other words, competitive advantage is never permanent, so it is reasonable to expect that the source of the positive NPV will disappear over time. You want to keep this in mind when you prepare your cash flow estimates.