According to recent surveys, most companies use discounted-cash-flow (DCF) methods to evaluate capital budgeting decisions. DCF methods typically assume that a project’s initial cash outlay (ICO) is known with certainty.
However, many types of initial outlays have substantial uncertainty, especially those involving the construction of a new facility. This risk affects not only the ICO, but it also affects subsequent depreciation tax shields. A proper capital budgeting analysis should incorporate the additional risk that is due to an uncertain ICO. We show that neither the typical practices employed by corporations nor two common techniques advocated in the finance literature, risk-adjusted discount rates and certainty equivalents, satisfactorily address ICO risk.
Sensitivity analysis is an effective way to address ICO risk, but the finance literature often overlooks the adjustments needed to satisfactorily address ICO risk within a sensitivity analysis. We fill this gap in the literature by showing the impact of ICO risk on the standard deviation of a project’s NPV. We then apply sensitivity analysis with the appropriate adjustments in a numerical example to illustrate the impact of ICO risk.
Source: Financial Decisions Online
Author: Michael C. Ehrhardt and John M. Wachowicz, Jr.