Capital Budgeting Decisions With Uncertain Cash Flows:
Learning Objectives:
-
Evaluate an investment
project that has uncertain cash flows.
The analysis in this chapter (capital
budgeting decisions) has assumed that all of the future cash flows are known
with certainty. However, future cash flows are often uncertain or difficult
to estimate. A number of techniques are available for handling this
complication. Some of these techniques are quite technical involving
computer simulations or advanced mathematical skills and are beyond the
scope of this website. However, we can provide some very useful information to
managers without getting too technical. An Example:
As an example of difficult to estimate
future cash flows, consider the case of investments in automated equipment.
The up front costs of automated equipment and the tangible benefits, such as
reductions in operating costs and lower wastages, tend to be relatively easy
to estimate. However, the tangible benefits, such as greater reliability,
greater speed, and higher quality, are more difficult to quantify in terms
of future cash flows. These intangible benefits certainly impact future cash
flows - particularly in terms of increased sales and perhaps higher selling
prices - but the cash flow effects are difficult to estimate. What can be
done? A fairly simple procedure can
be followed when the intangible benefits are likely to be significant.
Suppose, for example, that a company with a 12% discount rate
considering purchasing automated equipment that would have a 10-years
useful life. Also suppose that a discounted cash flow analysis of just
the tangible costs and benefits shows a negative net present value of
$226,000. Clearly, if the tangible benefits are large enough, they
could turn this negative net present value into a positive net present
value. In this case, the amount of additional cash flow per year from
the intangible benefits that would be needed to make the project
financially attractive can be computed as follows:
| Net
present value excluding the intangible benefits (negative) |
$(226,000) |
| Present
value factor for an annuity at 12% for 10 periods from
Future Value and Present
Value Tables page - Table 4 |
5.650 |
| |
|
|
Negative net
present value to be offset, $226,000 / Present value factor, 5.650
= $40,000 |
Thus, if the intangible benefits of the
automated equipment are worth at least $40,000 a year to the company, than
the automated equipment should be purchased. If in the judgment of
management, these intangible benefits are not worth $40,000 a year, then the
automated equipment should not be purchased.
This technique can be used in other situations
in which future cash flows are uncertain or difficult to estimate. For
example, this technique can be used when the salvage value is difficult to
estimate. To illustrate, suppose that all of the cash flows from an
investment in a supertanker have been estimated - other than its salvage
value in 20 years. Using a discount rate of 12%, management has determined
that the net present value of all of these cash flows is a negative $1.04
million. This negative net present value would be offset by the salvage
value of the supertanker. How large would the salvage value have to be to
make this investment attractive?
| Net
present value excluding salvage value (negative) |
$(1,040,000) |
| Present
value factor for an annuity at 12% for 20 periods 9from
Future Value and Present
Value Tables page - Table 3) |
0.104 |
| |
|
|
Negative net
present value to be offset, $1,040,000 / Present value factor,
0.104 = $10,000,000 |
Thus, if the salvage value of the tanker is
at least $10 million, its net present value would be positive and the
investment would be made. However, if management believes the salvage value
is unlikely to be as large as $10 million, the investment should not be
made.
|
In Business |
Managing the Financial Risk of Drug Research
Several different techniques can be used to
take into account uncertainties about future cash flows in capital
budgeting decisions. The uncertainties are particularly apparent in the
drug business where it costs an average of $359 million and 10 years to
bring a new drug through the government approval process and to market.
And once on the market, 7 out of 10 products fail to return the
company's cost of capital.
Merck & Co. manages the financial risk
and uncertainties of drug research using a research planning model it
has developed. The model, which produces net present value estimates and
other key statistics, is based on a wide range of scientific and
financial variables - most of which are uncertain. For example, the
future selling price of any drug resulting from current research is
usually highly uncertain, but managers at Merck & Co. can at least
specify a range within which the selling price is likely to fall. The
computer is used to draw a value at random, within the permissible
range, for each of the variables in the model. The model then computes a
net present value. This process is repeated many times, and each time a
new value of each of the variables is drawn at random. In this way,
Merck is able to produce a probability distribution for the net present
value. This can be used, for example, to estimate the probability that
the project's net present value will exceed a certain level. "What are
the payoffs of all this sophistication? In short, better decisions."
Source: Nancy A Nichols,
"Scientific Management at Merck: An interview with CFO Judy Lewent,"
Harvard Business Review, January - February 1994, pp. 89 - 99. |
|
