Capital Budgeting Decisions With Uncertain Cash Flows:

Learning Objectives:

1. 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 ResearchSeveral 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.