In this podcast episode, we discuss the problems with using a net present value analysis to evaluate capital budgeting proposals. Key points made are noted below.

This episode is about using net present value analysis in capital budgeting proposals. I’ve already talked about every other aspect of capital budgeting analysis, so this is the last episode in that area. I know, this means three out of the last four episodes will have been on capital budgeting – which is a lot of time on one topic. Still, I’ve seen companies almost go bankrupt by investing in the wrong assets, so this is worth one last episode to really nail down the topic.

The Nature of Net Present Value Analysis

So. Net present value analysis. This is when you estimate all of the cash inflows and outflows associated with a proposed fixed asset, and use a discount rate to arrive at the present value of those cash flows. Then you base the purchasing decision on the amount of that present value. This is the traditional way to decide whether to buy a fixed asset.

You may have noticed that I keep proposing alternatives to net present value. In Episode 45, I talked about basing budgeting decisions on whether an asset was involved with increasing the throughput of a business. And then in Episodes 144 and 145, I covered the use of things like asset standardization and feature reduction. Basically, all of these alternatives are designed to give you a very precise analysis of exactly why you want a fixed asset, and what features it should have.

Problems with Net Present Value Analysis

I haven’t been focusing on net present value, because I have some discomfort with how applicable it is, and how accurate it is. Here are a few points to consider.

First, can you even trace any revenue-related cash inflows to a specific piece of equipment? In a lot of cases, there aren’t any. Instead, revenue can only be associated with a cluster of equipment, like an entire production line.

And yet, cash benefits keep appearing in fixed asset purchase proposals. Now, those cash benefits may not be related to revenues. Instead, they could be generated by projected reductions in existing expenses. For example, some automation may result in a reduction in labor expenses.

Then the question becomes, will those savings actually be realized? In a lot of cases, companies have a hard time eliminating expenses.

After all, the first law of financial analysis is that all expenses will continue unless acted upon by an outside force. I just made that up, but the point is that expenses are sticky. They’re hard to eliminate. And also, a cash projection may be based on an expense reduction that’s incremental, and which therefore can’t happen. For example, can you really achieve a reduction in cash outflows by cutting 10% of the working hours of a salaried employee? Since the employee is salaried and is therefore going to be paid no matter what, the projected expense reduction isn’t going to happen.

And then let’s look at the cash outflows. Are you really sure about the expenditure projections? Oh, sure, everyone knows what the purchase price is, but what about the costs of installation and training? For heavy equipment, did you include the cost of preparing the site? Pouring a concrete pad? Wiring? Testing? How about permits? And then, what about the cost of any delays in getting it on line? Any related working capital? In short, I’ve seen some pretty amazing cost overruns that obliterated the original projections – to the point where a healthy initial estimate of net present value turned negative before the installation had even been completed.

And then, what about that discount rate? It’s generally supposed to be based on the corporate cost of capital, or maybe the incremental cost of capital. How many companies know what their cost of capital is? For a private company that’s funded mostly with equity, the cost of capital is probably only a vague concept – and that means the discount rate being used could be off by a large amount. And if the cash flows being estimated stretch way out into the future, the discount rate can have a hell of an impact on the net present value.

These problems may not result in especially bad outcomes as long as the person preparing the net present value analysis is conscientious about forecasting reasonable cash flow information. But that isn’t always the case. Any number of managers are willing to fudge their cash flow projections to create a present value that they know will be accepted.

You can usually figure out which managers fudge their numbers after the fact, but the trouble is that it may be way after the fact – to the point where the manager no longer even works for the company.

In short, net present value is comprised of nothing but forecasted information, and those forecasts can be seriously wrong. And the longer in the future those cash flows are projected, the more wrong they can be. And yet, you have to make decisions based on something. And actually, cash flow is one of the better methods for evaluating a lot of different kinds of business decisions. So, how can we adapt the net present value concept to make it more usable?

How to Improve Net Present Value Analysis

Well, here are some suggestions. First, don’t use it for small purchases. Below a certain cutoff level, it’s not worth the time to develop cash forecast information – if it’s even available. Instead, give managers a pool of cash that they can invest, using their best judgment. This won’t represent a massive percentage of the company’s available cash, but it should make the purchasing process more efficient for smaller acquisitions.

Next, base cash flows on throughput analysis as much as you can. This gives you better cash inflow information – which is otherwise pretty difficult to obtain. If you want to learn more about throughput, please go back to Episode 45.

And then, for any remaining projects, use a high-medium-low analysis for cash flows, so you can also see the best case and especially the worst case scenarios. This is much better than using a single, middle-of-the-road case. I tend to spend more time reviewing the worst case scenario than the middle scenario.

And finally – and this is an important one – assign all purchasing proposals that contain net present values to a financial analyst for a detailed review. The same person should do all of these analyses, so they gain some experience in the issues to look for, and how these proposals can be fudged.

And even though I just said “finally,” here’s one more. When you audit expense reports, and a problem comes up on someone’s expense report, the normal procedure is to review all of that person’s expense reports in the future. The same concept applies to net present value. If you even catch a hint of someone fudging their numbers, flag them for a more intensive review from that point forward.

So, in summary, is net present value a bad thing? No. Cash flow is a useful tool. However. You really should be skeptical when reviewing cash flow projections, as well as how they’re being discounted to their present value.

If you take into account the concerns I’ve raised here, it may prevent an incorrect investment.