Far too many risk-adjusted NPV calculations are flawed because they combine aggregate risk with NPV. Instead, use a simple Decision Tree to combine phase-specific risk and cash flow to create a technically correct eNPV.

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CALCULATING RISK-ADJUSTED NPV (eNPV) –
THE RIGHT WAY
PROJECT & PORTFOLIO VALUE CREATION

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Risk-adjusted NPV (eNPV) – calculations based on combining
aggregate probability of success with NPV can be terribly wrong
CASE STUDY 1: Consider a project which has just entered Phase 1 where phase-specific
probabilities of success and after-tax costs are shown below. If the aggregate probability
of success of 0.11 is applied to the commercial NPV of $603M, the eNPV would be
calculated as $69.19M.
PHASE 1 PHASE 2 PHASE 3 FDA AGGREGATE
p(SUCCESS) 0.90 0.25 0.60 0.85 0.11
COST ($M) -10 -35 -100 -2 -147
COMMERCIAL
NPV ($M)
750
FLAWED eNPV
($M)
= 0.11*(750+(-10-35-100-2) = 0.11*603 69.19
On the other hand, if phase-specific probabilities of success and after-tax costs are taken
into account, the eNPV can be shown to be very different from $69.19M as described in
Case Studies 2 & 3.

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Risk-adjusted NPV (eNPV) – calculations based on Decision
Tree analysis with phased risk and cost decomposition (I)
CASE STUDY 2: Exactly the same data as Case Study 1 but, using Decision Tree analysis,
the eNPV would be calculated as $21.79M.

4. 4
Copyright 2016 Project & Portfolio Value Creation.
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Risk-adjusted NPV (eNPV) – calculations based on Decision
Tree analysis with phased risk and cost decomposition (II)
CASE STUDY 3: The same data as Case Study 1 except that Phase 2 and Phase 3
probabilities of success are switched (without changing the aggregate probability of
success) and, using Decision Tree analysis, the eNPV would be calculated as -$9.71M.

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Copyright 2016 Project & Portfolio Value Creation.
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Risk-adjusted NPV (eNPV) calculations – important lessons
learned
 A project with a positive NPV, when combined with an aggregate probability of success, could not
have a negative eNPV. However, many early stage projects have negative eNPVs because their
aggregate probabilized negative cash flows exceed their aggregate probabilized positive cash flows
 It is important to determine a project’s phase-specific probabilities of success because these will
impact the eNPV
 A project with a high probability of success during an inexpensive, early phase and a low
probability of success during an expensive, late phase will likely have a low or negative eNPV
(Case Study 3)
 On the other hand, if the same project has a low probability of success during an inexpensive,
early phase and a high probability of success during an expensive, late phase, it will likely have
a modest or high positive eNPV (Case Study 2)
 At Stage Gate Reviews, if the eNPV is not generated properly, a correct option value for the
next phased investment of an asset could not be derived defensibly making a ‘Go/No Go’
decision unnecessarily difficult
 If Case Study 1 were a Licensing opportunity, and on the basis of eNPV alone, you would likely
buy the asset for $21.79M if its phase-specific risks appeared as in Case Study 2. On the other
hand, if the phase-specific risks appeared as in Case Study 3, you would certainly not buy the
asset (-$9.71M). But, if the eNPV were not generated correctly, you would likely always be
tempted to buy the asset for $69.19M
 Decision Trees also provide a means of double-checking financial calculations from a probabilized
Income Statement and facilitate portfolio consolidation.