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The DCF Approach to Capital Budgeting Decision-Making
CHAPTER 5
The DCF Approach to Capital Budgeting Decision-Making Diane M. Lander Department of Finance and Economics Southern New Hampshire University Manchester, New Hampshire, USA
Karyl B. Leggio Henry W. Bloch School of Business and Public Administration University of Missouri at Kansas City Kansas City, MO, USA
Introduction In the capital budgeting process, management must decide which long-term and, often times, high dollar assets the firm is going to acquire. Such decisions are based both on the firm’s strategic plan and expectations and the resulting asset valuations and risk assessments. The assets management decides to acquire may be purchased intact from other firms for a price or they may be manufactured in-house for a building cost. Sometimes an asset is acquired by purchasing another firm in its entirety. Finance academicians have long proposed that corporate managers use a discounted cash flow (DCF) approach for making capital budgeting decisions.1 This traditional valuation framework ties directly to finance theory, where the objective of corporate management decision-making is stated to be maximize the value of the firm, and focuses on what finance considers to be the most, maybe even the only, important valuation factor – the present
1
For a survey and discussion of managerial capital budgeting practices, see Farragher, Edward J., Robert T. Kleiman, and Anandi P. Sahu. Current Capital Investment Practices, Engineering Economist, Volume 44 Issue 2, 1999, 137–150.
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value (PV) of expected cash flows. According to finance, the value of any asset – real, as in a factory, or financial, as in a share of common stock – is determined by the magnitude, timing, and risk of the after-tax net cash flows the asset is expected to generate over its life.
The DCF Approach The DCF approach to capital budgeting is mathematically relatively straightforward, and results in determining the net value of a project, in today’s dollars, adjusted for risk. A sixstep DCF valuation process is described below. Others may suggest, for example, a fivestep process or a seven-step process, but, regardless of the number of steps delineated, the tasks to complete are the same. 1. The firm estimates, based on current expectations about future market conditions, the revenues and costs both relevant to the project and incremental to the firm. A capital budgeting analysis is not the place to bury revenues and costs relating to other firm activities. Sunk and allocated project costs, although needed for purposes of full project accounting, are not included because they are not cash flows incremental to the firm. These revenue and cost forecasts also should be adjusted for inflation. 2. From the forecasts, the firm creates pro forma accounting statements, which are then used to derive the per period free cash flows (FCFs) expected to occur over the forecast period.2 Given that FCFs are defined to be net after-tax cash flows available to pay all providers of capital, FCFs are cash flows (i.e., not earnings) that account for all operating and investing activity (short-term and long-term), but do not account for any financing activity (e.g., interest expense, debt repayment, dividends, new stock issued). The pro forma statements are also used for a financial analysis (common size statements, ratios, etc.) to verify the earnings based viability and financial performance of the project, or of the firm given the project. 3. The firm next determines a final, or terminal, value. If a project is finite lived, a net salvage value (NSV), representing the salvage value net of taxes, is computed. If a project is infinite lived, a horizon value (HV), representing the value of the expected FCFs from the end of the forecast period on, is computed. 4. The firm discounts to the present the per period FCFs and the terminal value, taking into account the time value of money and the riskiness of the FCFs. That is, each cash flow is discounted accounting for both when the cash flow will be received and how risky the cash flow is. When the project has the same risk level as the firm overall, the discount rate appropriate to use with FCFs is the firm’s weighted average cost of capital (WACC). The WACC represents the firm’s on average cost of capital, and accounts for all (after-tax) financing effects (i.e., returns to the debt holders, preferred stockholders, and common stock holders). Adding up the present values of the individual cash flows results in a sum, called the PV of the project, that represents the value of the project in today’s dollars adjusted for risk.
2
There are different types of cash flows (e.g., free cash flows, flows to equity). The type of cash flow most often associated with capital budgeting and most commonly presented in financial management texts is free cash flows.
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5. The fifth step is to subtract the initial expenditure, or purchase price, from the project’s PV. If expenditures occur over a period of time, the total PV of the expenditures is subtracted. The resulting value is the project’s net PV (NPV), and the decision rule is to accept all NPV 0 projects. a. If the NPV is greater than zero, the PV of the project’s FCFs exceeds the PV of its costs, meaning that the project earns more than enough to pay all providers of capital their expected returns. Because the excess accrues to the common shareholders, NPV positive projects increase firm value and create shareholder wealth. b. Technically, firms would be indifferent to NPV zero projects because the PV of the project’s FCFs only equals the PV of its costs. In other words, the project earns exactly enough to pay all providers of capital their expected returns, and firm value and shareholder wealth neither increase nor decrease. In practice, however, firms tend to look favorably on NPV zero projects. NPV positive projects are not so easy to find, and NPV zero projects do earn the shareholders their required rate of return. c. The traditional decision rule says that firms should not accept NPV negative projects. For these projects, the PV of the project’s FCFs is less than the PV of its costs. Since, in this case, the shortfall accrues to the common shareholders, accepting NPV negative projects will decrease firm value and destroy shareholder wealth. 6. The sixth and last step of an NPV analysis is to perform a quantitative risk assessment of the project to determine its value drivers and to find its range of exposure. The long-established and commonly used risk assessment techniques are sensitivity analysis, scenario analysis, and simulation. In practice, sensitivity analysis is most commonly used.3 A sensitivity analysis determines the primary drivers of project value and the range for each that results in positive project NPVs. Then the available slack in the value drivers’ forecasts is compared to the firm’s ability to forecast accurately, giving an indication of confidence in the investment decision. If the available slack in the value drivers’ forecasts exceeds the firm’s ability to forecast accurately, that is good news. If, however, the slack in the value drivers’ forecasts is narrower than the firm’s ability to forecast accurately, the project’s NPV may well turn negative as the project is implemented. Limitations of NPV analysis The apparent straight forwardness of the DCF approach and NPV calculation may suggest that traditional capital budgeting decision-making is simply a matter of forecasting, discounting, and summing. That impression, in fact, is not an accurate one. In addition, all valuation frameworks have modeling constraints and underlying assumptions, both explicit and implicit, that impose limitations on the analyses and reduce the merit of the resulting valuations. A DCF analysis is no exception. Below we discuss limitations of the DCF approach that are related to FCFs, discount rates, and option-like project characteristics. For completeness’ sake, we should mention 3
Farragher, Edward J., Robert T. Kleiman, and Anandi P. Sahu. Current Capital Investment Practices, Engineering Economist, Volume 44 Issue 2, 1999, 143–144 and Table 4.
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that there are three additional technical assumptions underlying the DCF approach to capital budgeting. The first is that capital markets are perfect and complete, and the second is that governments do not exist or are neutral. Most managers recognize that these assumptions do not altogether hold, and understand that, although they are needed for the theory, they are often violated in practice. The third technical assumption, that NPV positive projects exist only when firms can exploit temporary competitive advantages, is, for the most part, true. Unless an existing firm in an industry has some kind of market power, such as being a monopoly, new firms will enter a market where there are apparent profits, and eventually compete away any NPV positive opportunities. Cash flow limitations Forecasting is a difficult task under any circumstances, even when the best of information about the future is available, and a DCF valuation requires management to forecast a project’s FCFs into an uncertain future. Furthermore, project value is not an absolute or constant. As the firm forms new expectations about the future, either because new information becomes available or because of a new way of looking at current information, the firm and other market participants will adjust a project’s value. Two other related cash flow assumptions are that the expected values of the individual cash flows are given and that these expected values are acceptable proxies for the cash flows’ distributions. If the expected values are not given, the analysis requires the relevant distributions for and related subjective probabilities of the individual and uncertain cash flows be known, both of which may be difficult to obtain or to estimate. Second, there are times when the expected values of the future uncertain cash flows may not best represent the cash flows’ distributions. For example, if a cash flow’s distribution is skewed, the expected value will be different from the mode, and this may have implications for project value. Moreover, when cash flow uncertainty is high, replacing future cash flow distributions with their expected values may lead to errors in the discount rate estimate as well. Discount rate limitations Once the expected FCFs for each period in the life of the project have been calculated, the next step is to discount them. An implicit discount rate assumption of the DCF valuation framework is that the discount rate appropriately adjusts for the time value of money and all relevant risk. A second assumption is that the discount rate is known, constant, and a function of only project risk. In practice, however, determining the appropriate discount rate, and, thus, the discount factors, to apply to the project FCFs is one of the most difficult, and often controversial, aspects of any DCF analysis. The difficulty comes in determining just how much more expected return (i.e., risk premium) is appropriate for a given risky project. An equilibrium asset pricing model, such as the capital asset pricing model (CAPM), could be used, but rarely are there project market prices to use for determining the required inputs, such as the project’s beta. Although a replicating, or twin, asset can be used for determining a project’s discount rate, such an asset is often not available. Furthermore, project risk is not dependent on just one factor. For example, project risk may also depend on the remaining life of the project, current firm profitability, and the degree to which managers can modify the investment and operating strategy. In other words, the discount rate is more than likely uncertain, time varying, and state and investment and operating strategy dependent.
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Because determining risk adjusted discount rates is so problematic, firms often default to using their WACC as a proxy for the opportunity cost of all projects. This simplification typically introduces biases into the capital budgeting decision-making process, and these decision-making biases become systematic.4 For example, a project that is less risky than the firm will be undervalued and may be rejected. If the project is truly an NPV positive project when the correct project discount rate is used, by rejecting the project, the firm loses out on the opportunity to increase firm value and shareholder wealth. On the other hand, a project that is more risky than the firm will be overvalued and may be accepted. If the project is truly an NPV negative project when the correct project discount rate is used, by accepting the project, the firm destroys shareholder wealth.
Option-like project characteristics We now understand that, in certain circumstances, the DCF technique undervalues projects. Academicians first accounted for this by focusing on the possibility of downwardly biased expectations of future cash flows (putting too high a probability on low cash flows) or on the possibility of excessively high discount rates (overly adjusting for risk). But even if managers make errors in estimating project cash flows or determining discount rates, there is no reason to believe that such errors are always in the conservative direction. The likely source of project undervaluation is the DCF technique itself – a DCF analysis is linear in nature and, at the time of the analysis, the future is taken to be static. The DCF approach assumes that once the decision to invest is made and the future uncertainties start to reveal themselves, management will not change the project’s investment or operating strategy. In other words, managers are passive and the project cannot be expanded, contracted, re-directed, temporarily shut-down, or abandoned. But this is just not how managers behave. In practice, projects are actively managed and changed as the investment and operating environments change. Moreover, managers have always recognized that some projects appearing to have a zero, or even negative, NPV may still add value to the firm, and have justified investing in such projects by claiming that the projects have strategic, or hidden, value. That is, the negative NPV project carries with it some type of strategic option – production, growth, abandon, defer – that has value, but this option value is not included in the project’s NPV. Production options account for management’s ability to alter the operating scale by expanding or contracting capacity as demand conditions change or to switch production inputs or outputs in response to price changes. Such actions are common and well understood, but not modeled in a traditional DCF analysis. Growth options are value-creating actions that managers can take once they see how the future is unfolding, and are more than just expanding the current lines of business or production capacity. Look no further than the computer industry. The very first line of computers was probably not a positive NPV venture. If demand for these first computers were 4 Rubinstein, Mark E. A Mean-Variance Synthesis of Corporate Finance Theory, Journal of Finance, Volume 28, Issue 1, 1973, 167–181 (graph on page 172).
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low, the firm would stop the project and move on to new and different projects. On the other hand, if these first computers were successful, then later versions and generations could be successful, and highly profitable too. In fact, the mainframe computer being successful opened the opportunity to develop the mini computer, and the mini computer being successful opened the opportunity to develop the desktop computer, and the desktop computer being successful opened the opportunity to develop the laptop computer. Similarly, if online book buying is successful for Amazon.com, maybe then so will be online CD buying, and then online electronics buying, and then online tools and hardware buying, and so on. The third type of strategic option is the abandonment option. Abandonment options allow managers to take actions that protect the firm from (additional) loss, and, similar to growth options, are more than just contracting the current lines of business or production capacity. An example is when management is able to prematurely terminate a project if sufficient market demand does not develop, or does not develop soon enough. The Edsel and New Coke did not have long market lives. A classic example is that of the Research & Development process where, for example, management can terminate the production of a new drug if the clinical trials show that the new drug is not effective or has severe side effects. The final strategic option we discuss is the option to defer.5 A DCF analysis assumes that projects are totally reversible and now-or-never opportunities. The totally reversible assumption says that, if the firm goes ahead with the project, the firm can, at any time, stop the project and recoup everything it has invested to that point. That is, the firm can become whole as if it never invested in the project at all. This is typically not true for real world projects. There is usually some cost to undertaking a project that cannot be recouped, and, if there are sunk costs to investing, managers must be careful about when any investment is made. But the now-or-never assumption means that a DCF analysis typically considers only whether a project be undertaken now or if it should be rejected – forever. There is no considering if the firm has either the opportunity of investing this year or waiting until next year to invest. There is no considering when to invest. A DCF analysis simply ignores any invest later windows of opportunity.6 Nevertheless, managers do delay making decisions, and they do so because the future is uncertain. Delaying allows the uncertain future to resolve to some extent and the managers then to obtain more information. And if management can wait before deciding whether or not to invest, this ability to wait has value that must somehow be taken into account.7 So a DCF valuation that includes no consideration for this option to wait, not only tends to undervalue a project, but also may direct the firm to invest in the project too 5
Dixit, A.K. and Pindyck, R.S. Investment Under Uncertainty. NJ: Princeton University Press, 1994. For a detailed example, see Feinstein, Steven, P. and Diane M. Lander. A Better Understanding of Why NPV Undervalues Managerial Flexibility, The Engineering Economist, Volume 47, No 3, 2002, 418–435. 7 Waiting to decide also can be costly. For a detailed example of the costs to waiting, see Diane M. Lander, Do Foregone Earnings Matter When Modeling and Valuing Real Options: A Black-Scholes Teaching Exercise, Financial Practice and Education, Volume 10, No 2, 2000, 121–127. 6
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early. Consider a project that has a negative NPV given that investment must take place now, but may have a positive NPV if investment in the project is deferred to the future. Renewable energy might be such an example: a renewable energy generation plant is more likely to be valuable in the future when traditional energy supplies are almost exhausted. Since firms are really just a collection of projects, a firm itself can be viewed as a project and valued using the DCF technique, which is how many market analysts decide which stocks to recommend and many Chief Financial Officers (CFOs) decide which firms to merge with or acquire. Yet, just as the DCF technique, in certain circumstances, undervalues projects, it similarly undervalues firms. That is, the market value of a firm most often exceeds its DCF value because of its production, growth, abandonment, and defer strategic options. Considering only growth options suggests that the market value of a firm is composed of two parts. The first component is the DCF value of the firm’s assets currently in place. That is, holding the firm’s existing asset level constant, the DCF value of the firm is the PV of the future FCFs the firm is expected to generate from this level of assets. The second component of a firm’s market value, then, is the value of its growth opportunities. That is, allowing the firm’s asset base to expand in the future, the value of the firm’s growth opportunities is the PV of the future FCFs the firm is expected to generate from additional assets. Carl Kester of Harvard University estimated that, for large publicly traded firms, growth opportunities not taken into account in a DCF firm valuation represent between 7 and 88% of a firm’s market value, depending on the firm (industry) and the assumed earnings capitalization rate.8
Conclusion The DCF approach to capital budgeting ties directly to finance theory, focuses on cash flows as the source of value, and, despite its limitations and shortcomings, continues to be taught in business schools and is widely used in practice.9 Since managers are rarely willing to spend time, effort, and resources on pointless activities, managers must see practical value in using DCF analyses. Yet, in practice, firms can determine NPVs, but whether firms do or do not use the resulting valuations in their actual decision-making is difficult to assess.10 The real question is: Does a DCF analysis yield a near optimal decision when used for capital budgeting decision-making? Do firms that use a DCF analysis for valuing projects and follow the NPV decision rule tend to outperform firms that do not? That is, will firms using the DCF approach make better capital budgeting decisions? Will these firms tend to invest in value adding projects and reject value-destroying projects more often than firms not using the DCF approach? Maybe not.
8
Kester, W.C. “Today’s Options for Tomorrow’s Growth.” Harvard Business Review (March–April) 1984, 153–160. Farragher, Edward J., Robert T. Kleiman and Anandi P. Sahu. Current Capital Investment Practices, Engineering Economist, Volume 44 Issue 2, 1999, 137–150. 10 Alessandri, Todd. A Portfolio of Decision Processes. Unpublished dissertation. University of North Carolina, Chapel Hill 2002. 9
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A DCF analysis, like any other valuation framework, has modeling constraints and underlying assumptions that impose limitations on the analyses and reduce the merit of the resulting valuations. But it also is well accepted that the traditional DCF methodology is often not an adequate capital budgeting decision-making framework, systematically undervaluing projects (and firms) when there are future discretionary investment opportunities – when there is a wide degree of managerial flexibility. We now know that the DCF approach to capital budgeting (1) yields nearly optimal decisions only in relatively certain environments; (2) incorrectly assumes investments are reversible or now-or-never opportunities; (3) incorrectly assumes firms hold real assets passively; and (4) cannot incorporate project strategic value. Brennan and Schwartz state, “… the classical approach may be likened to valuing a stock option contract while ignoring the right of the holder not to exercise when it is unprofitable.”11 What is missing in the DCF approach is the ability to value managerial flexibility – to value real options. When dealing with real options, a project investment decision is to be made, but that decision can be deferred to a later date, and, since the future is uncertain, most of the time, more information can be gained by waiting. If the real options present in a project are sufficiently valuable, a positive NPV can become more positive, or a negative NPV can become positive, once the value of the real options is taken into account. Yet these real options are not accounted for, nor can they be accurately valued, using a DCF valuation framework. The traditional DCF approach to capital budgeting assumes that the payoffs to a project are symmetrical and the project will absorb the effect of whichever outcome occurs. The payoff to an option, however, is not symmetric. For an option, the upside potential remains as is, but the ability to walk away if a negative outcome occurs truncates, may even eliminate, any downside effect. This asymmetric, or kinked, payoff is the classic characteristic of all options, financial and real. By using option pricing techniques, strategic options embedded in projects can be modeled and valued, and projects, themselves, can be modeled and valued as real options as well. The real options approach to capital budgeting gives the academicians, strategists, managers, and analysts a way to extend the traditional DCF analysis and now also account for project strategic value.
11 Brennan, M.J. and Schwartz, E.S. A New Approach to Evaluating Natural Resource Investments. Midland Corporate Finance Journal, 3 (Spring), 1985a, 37–47.
The DCF Approach to Capital Budgeting Decision-Making Diane M. Lander Department of Finance and Economics Southern New Hampshire University Manchester, New Hampshire, USA
Karyl B. Leggio Henry W. Bloch School of Business and Public Administration University of Missouri at Kansas City Kansas City, MO, USA
Introduction In the capital budgeting process, management must decide which long-term and, often times, high dollar assets the firm is going to acquire. Such decisions are based both on the firm’s strategic plan and expectations and the resulting asset valuations and risk assessments. The assets management decides to acquire may be purchased intact from other firms for a price or they may be manufactured in-house for a building cost. Sometimes an asset is acquired by purchasing another firm in its entirety. Finance academicians have long proposed that corporate managers use a discounted cash flow (DCF) approach for making capital budgeting decisions.1 This traditional valuation framework ties directly to finance theory, where the objective of corporate management decision-making is stated to be maximize the value of the firm, and focuses on what finance considers to be the most, maybe even the only, important valuation factor – the present
1
For a survey and discussion of managerial capital budgeting practices, see Farragher, Edward J., Robert T. Kleiman, and Anandi P. Sahu. Current Capital Investment Practices, Engineering Economist, Volume 44 Issue 2, 1999, 137–150.
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value (PV) of expected cash flows. According to finance, the value of any asset – real, as in a factory, or financial, as in a share of common stock – is determined by the magnitude, timing, and risk of the after-tax net cash flows the asset is expected to generate over its life.
The DCF Approach The DCF approach to capital budgeting is mathematically relatively straightforward, and results in determining the net value of a project, in today’s dollars, adjusted for risk. A sixstep DCF valuation process is described below. Others may suggest, for example, a fivestep process or a seven-step process, but, regardless of the number of steps delineated, the tasks to complete are the same. 1. The firm estimates, based on current expectations about future market conditions, the revenues and costs both relevant to the project and incremental to the firm. A capital budgeting analysis is not the place to bury revenues and costs relating to other firm activities. Sunk and allocated project costs, although needed for purposes of full project accounting, are not included because they are not cash flows incremental to the firm. These revenue and cost forecasts also should be adjusted for inflation. 2. From the forecasts, the firm creates pro forma accounting statements, which are then used to derive the per period free cash flows (FCFs) expected to occur over the forecast period.2 Given that FCFs are defined to be net after-tax cash flows available to pay all providers of capital, FCFs are cash flows (i.e., not earnings) that account for all operating and investing activity (short-term and long-term), but do not account for any financing activity (e.g., interest expense, debt repayment, dividends, new stock issued). The pro forma statements are also used for a financial analysis (common size statements, ratios, etc.) to verify the earnings based viability and financial performance of the project, or of the firm given the project. 3. The firm next determines a final, or terminal, value. If a project is finite lived, a net salvage value (NSV), representing the salvage value net of taxes, is computed. If a project is infinite lived, a horizon value (HV), representing the value of the expected FCFs from the end of the forecast period on, is computed. 4. The firm discounts to the present the per period FCFs and the terminal value, taking into account the time value of money and the riskiness of the FCFs. That is, each cash flow is discounted accounting for both when the cash flow will be received and how risky the cash flow is. When the project has the same risk level as the firm overall, the discount rate appropriate to use with FCFs is the firm’s weighted average cost of capital (WACC). The WACC represents the firm’s on average cost of capital, and accounts for all (after-tax) financing effects (i.e., returns to the debt holders, preferred stockholders, and common stock holders). Adding up the present values of the individual cash flows results in a sum, called the PV of the project, that represents the value of the project in today’s dollars adjusted for risk.
2
There are different types of cash flows (e.g., free cash flows, flows to equity). The type of cash flow most often associated with capital budgeting and most commonly presented in financial management texts is free cash flows.
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5. The fifth step is to subtract the initial expenditure, or purchase price, from the project’s PV. If expenditures occur over a period of time, the total PV of the expenditures is subtracted. The resulting value is the project’s net PV (NPV), and the decision rule is to accept all NPV 0 projects. a. If the NPV is greater than zero, the PV of the project’s FCFs exceeds the PV of its costs, meaning that the project earns more than enough to pay all providers of capital their expected returns. Because the excess accrues to the common shareholders, NPV positive projects increase firm value and create shareholder wealth. b. Technically, firms would be indifferent to NPV zero projects because the PV of the project’s FCFs only equals the PV of its costs. In other words, the project earns exactly enough to pay all providers of capital their expected returns, and firm value and shareholder wealth neither increase nor decrease. In practice, however, firms tend to look favorably on NPV zero projects. NPV positive projects are not so easy to find, and NPV zero projects do earn the shareholders their required rate of return. c. The traditional decision rule says that firms should not accept NPV negative projects. For these projects, the PV of the project’s FCFs is less than the PV of its costs. Since, in this case, the shortfall accrues to the common shareholders, accepting NPV negative projects will decrease firm value and destroy shareholder wealth. 6. The sixth and last step of an NPV analysis is to perform a quantitative risk assessment of the project to determine its value drivers and to find its range of exposure. The long-established and commonly used risk assessment techniques are sensitivity analysis, scenario analysis, and simulation. In practice, sensitivity analysis is most commonly used.3 A sensitivity analysis determines the primary drivers of project value and the range for each that results in positive project NPVs. Then the available slack in the value drivers’ forecasts is compared to the firm’s ability to forecast accurately, giving an indication of confidence in the investment decision. If the available slack in the value drivers’ forecasts exceeds the firm’s ability to forecast accurately, that is good news. If, however, the slack in the value drivers’ forecasts is narrower than the firm’s ability to forecast accurately, the project’s NPV may well turn negative as the project is implemented. Limitations of NPV analysis The apparent straight forwardness of the DCF approach and NPV calculation may suggest that traditional capital budgeting decision-making is simply a matter of forecasting, discounting, and summing. That impression, in fact, is not an accurate one. In addition, all valuation frameworks have modeling constraints and underlying assumptions, both explicit and implicit, that impose limitations on the analyses and reduce the merit of the resulting valuations. A DCF analysis is no exception. Below we discuss limitations of the DCF approach that are related to FCFs, discount rates, and option-like project characteristics. For completeness’ sake, we should mention 3
Farragher, Edward J., Robert T. Kleiman, and Anandi P. Sahu. Current Capital Investment Practices, Engineering Economist, Volume 44 Issue 2, 1999, 143–144 and Table 4.
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that there are three additional technical assumptions underlying the DCF approach to capital budgeting. The first is that capital markets are perfect and complete, and the second is that governments do not exist or are neutral. Most managers recognize that these assumptions do not altogether hold, and understand that, although they are needed for the theory, they are often violated in practice. The third technical assumption, that NPV positive projects exist only when firms can exploit temporary competitive advantages, is, for the most part, true. Unless an existing firm in an industry has some kind of market power, such as being a monopoly, new firms will enter a market where there are apparent profits, and eventually compete away any NPV positive opportunities. Cash flow limitations Forecasting is a difficult task under any circumstances, even when the best of information about the future is available, and a DCF valuation requires management to forecast a project’s FCFs into an uncertain future. Furthermore, project value is not an absolute or constant. As the firm forms new expectations about the future, either because new information becomes available or because of a new way of looking at current information, the firm and other market participants will adjust a project’s value. Two other related cash flow assumptions are that the expected values of the individual cash flows are given and that these expected values are acceptable proxies for the cash flows’ distributions. If the expected values are not given, the analysis requires the relevant distributions for and related subjective probabilities of the individual and uncertain cash flows be known, both of which may be difficult to obtain or to estimate. Second, there are times when the expected values of the future uncertain cash flows may not best represent the cash flows’ distributions. For example, if a cash flow’s distribution is skewed, the expected value will be different from the mode, and this may have implications for project value. Moreover, when cash flow uncertainty is high, replacing future cash flow distributions with their expected values may lead to errors in the discount rate estimate as well. Discount rate limitations Once the expected FCFs for each period in the life of the project have been calculated, the next step is to discount them. An implicit discount rate assumption of the DCF valuation framework is that the discount rate appropriately adjusts for the time value of money and all relevant risk. A second assumption is that the discount rate is known, constant, and a function of only project risk. In practice, however, determining the appropriate discount rate, and, thus, the discount factors, to apply to the project FCFs is one of the most difficult, and often controversial, aspects of any DCF analysis. The difficulty comes in determining just how much more expected return (i.e., risk premium) is appropriate for a given risky project. An equilibrium asset pricing model, such as the capital asset pricing model (CAPM), could be used, but rarely are there project market prices to use for determining the required inputs, such as the project’s beta. Although a replicating, or twin, asset can be used for determining a project’s discount rate, such an asset is often not available. Furthermore, project risk is not dependent on just one factor. For example, project risk may also depend on the remaining life of the project, current firm profitability, and the degree to which managers can modify the investment and operating strategy. In other words, the discount rate is more than likely uncertain, time varying, and state and investment and operating strategy dependent.
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Because determining risk adjusted discount rates is so problematic, firms often default to using their WACC as a proxy for the opportunity cost of all projects. This simplification typically introduces biases into the capital budgeting decision-making process, and these decision-making biases become systematic.4 For example, a project that is less risky than the firm will be undervalued and may be rejected. If the project is truly an NPV positive project when the correct project discount rate is used, by rejecting the project, the firm loses out on the opportunity to increase firm value and shareholder wealth. On the other hand, a project that is more risky than the firm will be overvalued and may be accepted. If the project is truly an NPV negative project when the correct project discount rate is used, by accepting the project, the firm destroys shareholder wealth.
Option-like project characteristics We now understand that, in certain circumstances, the DCF technique undervalues projects. Academicians first accounted for this by focusing on the possibility of downwardly biased expectations of future cash flows (putting too high a probability on low cash flows) or on the possibility of excessively high discount rates (overly adjusting for risk). But even if managers make errors in estimating project cash flows or determining discount rates, there is no reason to believe that such errors are always in the conservative direction. The likely source of project undervaluation is the DCF technique itself – a DCF analysis is linear in nature and, at the time of the analysis, the future is taken to be static. The DCF approach assumes that once the decision to invest is made and the future uncertainties start to reveal themselves, management will not change the project’s investment or operating strategy. In other words, managers are passive and the project cannot be expanded, contracted, re-directed, temporarily shut-down, or abandoned. But this is just not how managers behave. In practice, projects are actively managed and changed as the investment and operating environments change. Moreover, managers have always recognized that some projects appearing to have a zero, or even negative, NPV may still add value to the firm, and have justified investing in such projects by claiming that the projects have strategic, or hidden, value. That is, the negative NPV project carries with it some type of strategic option – production, growth, abandon, defer – that has value, but this option value is not included in the project’s NPV. Production options account for management’s ability to alter the operating scale by expanding or contracting capacity as demand conditions change or to switch production inputs or outputs in response to price changes. Such actions are common and well understood, but not modeled in a traditional DCF analysis. Growth options are value-creating actions that managers can take once they see how the future is unfolding, and are more than just expanding the current lines of business or production capacity. Look no further than the computer industry. The very first line of computers was probably not a positive NPV venture. If demand for these first computers were 4 Rubinstein, Mark E. A Mean-Variance Synthesis of Corporate Finance Theory, Journal of Finance, Volume 28, Issue 1, 1973, 167–181 (graph on page 172).
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low, the firm would stop the project and move on to new and different projects. On the other hand, if these first computers were successful, then later versions and generations could be successful, and highly profitable too. In fact, the mainframe computer being successful opened the opportunity to develop the mini computer, and the mini computer being successful opened the opportunity to develop the desktop computer, and the desktop computer being successful opened the opportunity to develop the laptop computer. Similarly, if online book buying is successful for Amazon.com, maybe then so will be online CD buying, and then online electronics buying, and then online tools and hardware buying, and so on. The third type of strategic option is the abandonment option. Abandonment options allow managers to take actions that protect the firm from (additional) loss, and, similar to growth options, are more than just contracting the current lines of business or production capacity. An example is when management is able to prematurely terminate a project if sufficient market demand does not develop, or does not develop soon enough. The Edsel and New Coke did not have long market lives. A classic example is that of the Research & Development process where, for example, management can terminate the production of a new drug if the clinical trials show that the new drug is not effective or has severe side effects. The final strategic option we discuss is the option to defer.5 A DCF analysis assumes that projects are totally reversible and now-or-never opportunities. The totally reversible assumption says that, if the firm goes ahead with the project, the firm can, at any time, stop the project and recoup everything it has invested to that point. That is, the firm can become whole as if it never invested in the project at all. This is typically not true for real world projects. There is usually some cost to undertaking a project that cannot be recouped, and, if there are sunk costs to investing, managers must be careful about when any investment is made. But the now-or-never assumption means that a DCF analysis typically considers only whether a project be undertaken now or if it should be rejected – forever. There is no considering if the firm has either the opportunity of investing this year or waiting until next year to invest. There is no considering when to invest. A DCF analysis simply ignores any invest later windows of opportunity.6 Nevertheless, managers do delay making decisions, and they do so because the future is uncertain. Delaying allows the uncertain future to resolve to some extent and the managers then to obtain more information. And if management can wait before deciding whether or not to invest, this ability to wait has value that must somehow be taken into account.7 So a DCF valuation that includes no consideration for this option to wait, not only tends to undervalue a project, but also may direct the firm to invest in the project too 5
Dixit, A.K. and Pindyck, R.S. Investment Under Uncertainty. NJ: Princeton University Press, 1994. For a detailed example, see Feinstein, Steven, P. and Diane M. Lander. A Better Understanding of Why NPV Undervalues Managerial Flexibility, The Engineering Economist, Volume 47, No 3, 2002, 418–435. 7 Waiting to decide also can be costly. For a detailed example of the costs to waiting, see Diane M. Lander, Do Foregone Earnings Matter When Modeling and Valuing Real Options: A Black-Scholes Teaching Exercise, Financial Practice and Education, Volume 10, No 2, 2000, 121–127. 6
The DCF approach to capital budgeting decision-making
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early. Consider a project that has a negative NPV given that investment must take place now, but may have a positive NPV if investment in the project is deferred to the future. Renewable energy might be such an example: a renewable energy generation plant is more likely to be valuable in the future when traditional energy supplies are almost exhausted. Since firms are really just a collection of projects, a firm itself can be viewed as a project and valued using the DCF technique, which is how many market analysts decide which stocks to recommend and many Chief Financial Officers (CFOs) decide which firms to merge with or acquire. Yet, just as the DCF technique, in certain circumstances, undervalues projects, it similarly undervalues firms. That is, the market value of a firm most often exceeds its DCF value because of its production, growth, abandonment, and defer strategic options. Considering only growth options suggests that the market value of a firm is composed of two parts. The first component is the DCF value of the firm’s assets currently in place. That is, holding the firm’s existing asset level constant, the DCF value of the firm is the PV of the future FCFs the firm is expected to generate from this level of assets. The second component of a firm’s market value, then, is the value of its growth opportunities. That is, allowing the firm’s asset base to expand in the future, the value of the firm’s growth opportunities is the PV of the future FCFs the firm is expected to generate from additional assets. Carl Kester of Harvard University estimated that, for large publicly traded firms, growth opportunities not taken into account in a DCF firm valuation represent between 7 and 88% of a firm’s market value, depending on the firm (industry) and the assumed earnings capitalization rate.8
Conclusion The DCF approach to capital budgeting ties directly to finance theory, focuses on cash flows as the source of value, and, despite its limitations and shortcomings, continues to be taught in business schools and is widely used in practice.9 Since managers are rarely willing to spend time, effort, and resources on pointless activities, managers must see practical value in using DCF analyses. Yet, in practice, firms can determine NPVs, but whether firms do or do not use the resulting valuations in their actual decision-making is difficult to assess.10 The real question is: Does a DCF analysis yield a near optimal decision when used for capital budgeting decision-making? Do firms that use a DCF analysis for valuing projects and follow the NPV decision rule tend to outperform firms that do not? That is, will firms using the DCF approach make better capital budgeting decisions? Will these firms tend to invest in value adding projects and reject value-destroying projects more often than firms not using the DCF approach? Maybe not.
8
Kester, W.C. “Today’s Options for Tomorrow’s Growth.” Harvard Business Review (March–April) 1984, 153–160. Farragher, Edward J., Robert T. Kleiman and Anandi P. Sahu. Current Capital Investment Practices, Engineering Economist, Volume 44 Issue 2, 1999, 137–150. 10 Alessandri, Todd. A Portfolio of Decision Processes. Unpublished dissertation. University of North Carolina, Chapel Hill 2002. 9
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A DCF analysis, like any other valuation framework, has modeling constraints and underlying assumptions that impose limitations on the analyses and reduce the merit of the resulting valuations. But it also is well accepted that the traditional DCF methodology is often not an adequate capital budgeting decision-making framework, systematically undervaluing projects (and firms) when there are future discretionary investment opportunities – when there is a wide degree of managerial flexibility. We now know that the DCF approach to capital budgeting (1) yields nearly optimal decisions only in relatively certain environments; (2) incorrectly assumes investments are reversible or now-or-never opportunities; (3) incorrectly assumes firms hold real assets passively; and (4) cannot incorporate project strategic value. Brennan and Schwartz state, “… the classical approach may be likened to valuing a stock option contract while ignoring the right of the holder not to exercise when it is unprofitable.”11 What is missing in the DCF approach is the ability to value managerial flexibility – to value real options. When dealing with real options, a project investment decision is to be made, but that decision can be deferred to a later date, and, since the future is uncertain, most of the time, more information can be gained by waiting. If the real options present in a project are sufficiently valuable, a positive NPV can become more positive, or a negative NPV can become positive, once the value of the real options is taken into account. Yet these real options are not accounted for, nor can they be accurately valued, using a DCF valuation framework. The traditional DCF approach to capital budgeting assumes that the payoffs to a project are symmetrical and the project will absorb the effect of whichever outcome occurs. The payoff to an option, however, is not symmetric. For an option, the upside potential remains as is, but the ability to walk away if a negative outcome occurs truncates, may even eliminate, any downside effect. This asymmetric, or kinked, payoff is the classic characteristic of all options, financial and real. By using option pricing techniques, strategic options embedded in projects can be modeled and valued, and projects, themselves, can be modeled and valued as real options as well. The real options approach to capital budgeting gives the academicians, strategists, managers, and analysts a way to extend the traditional DCF analysis and now also account for project strategic value.
11 Brennan, M.J. and Schwartz, E.S. A New Approach to Evaluating Natural Resource Investments. Midland Corporate Finance Journal, 3 (Spring), 1985a, 37–47.