Watch for pitfalls of discounted cash flow techniques

Healthcare Financial Management, April, 1991 by Chee W. Chow, Alan H. McNamee

Nonetheless, intangible benefits should not be valued at zero in an analysis. "Zero is, after all, no less arbitrary than any other number. Conservative accountants who assign zero values to many intangible benefits prefer being precisely wrong to being vaguely right."(e)

One way to include a hard-to-quantify factor in capital budgeting decisions is to conduct a sensitivity analysis of the project. If a proper DCF analysis has been completed for all tangible factors and the outcome of the analysis is unfavorable, a manager should, rather than reject the project outright, estimate the annual cash inflows required for the investment to attain a positive NPV or an acceptable IRR.

Instead of an exact dollar amount estimate, all that is required is an assessment of whether the omitted benefits are above or below some number. Experienced financial managers should be able to estimate, for example, that an investment in new technology may produce $100,000 to $200,000 of intangible benefits per year but not $800,000 to $1 million. While not precise mathematics, this type of estimating helps to set meaningful parameters on items that should not be ignored in an analysis.

INFLATION EFFECTS. Inflation is an inevitable part of economics, and capital budgeting proposals must appropriately incorporate its expected effects.(f) Often, however, inflation is not accounted for. Because capital projects typically involve near-term net outflows and long-term net inflows, omitting the expected effects of inflation will exclude proportionally more of a project's net inflows than outflows. Understatement also increases with the length of a cash flow's term, leading to a potential bias against long-term projects.

For example, if a laboratory is considering a $100,000 purchase of equipment expected to last three years and to reduce the costs of laboratory tests by $50,000 per year in today's dollars, ignoring inflation means that the equipment's $100,000 cost would be weighted against three future annual savings of $50,000 each.

But if the expected annual inflation rate is 5 percent, amounts of annual savings would increase. Instead of an expected savings of $50,000 in the first year, $52,500 ($50,000 x 1.05) would be saved. By year three, the annual expected savings would grow to $57,881.25 ($50,000 x [1.05.sup.3]) At the same time, the equipment's cost would not be affected because it is current.

Consequently, leaving out expected inflation effects understates future benefits. While understatement may be only $2,500 in year one, it will grow to $7,881.25 in year three because of compounding. The more distant a cash flow (or the longer a project's term), the greater the understatement from ignoring expected inflation effects.

In the example, using a $50,000 cost savings figure is not necessarily incorrect. This figure can represent expected annual savings in constant rather than nominal dollars. But constant dollar amounts often are discounted using an organization's nominal cost of capital, which already includes an allowance for expected inflation (as in the case of interest rates on bank loans). The result is a double charge for expected inflation, with an additional bias against more distant cash flows.