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📄 Contents

  1. Making Uncertainty Work for You
  2. Managing Uncertainty
  3. NPV and DCF: When and When Not to Use Them
This chapter is from the book

NPV and DCF: When and When Not to Use Them

As we alluded to earlier, the overuse of discounted cash flow analysis that leads to the ubiquitous NPV calculation is simply inappropriate when applied to uncertain investments, whether they are new products, entering new markets, or launching bold strategies. We think these tools have done much to stifle the entrepreneurial spirit in many companies. This is a strong statement, and we get pushback from many financial managers because NPV is the metric used across the board, so why rock the boat? Of course, our response is that rocking the boat is exactly how to find opportunities, especially if you are the first to do so.

This is not to say that NPV should be abandoned—far from it. Ultimately, the uncertainty in innovative projects will be engineered down to a point where using NPV is perfectly appropriate!

  • When to use NPV: So, let's look at where DCF works and should be used. Discounted cash flow was "invented" to value corporate bonds. Here it is brilliant, because we know everything with a great deal of certainty. With a corporate bond, we know for sure what the time frame of the cash flow is by just looking at the indenture. If it is a 20-year bond, we have 240 monthly cash flow payments. The amount of each cash flow payment is also known for sure (from the indenture, by looking at the coupon rate). Therefore, the only unknown is the appropriate discount rate with which to present value the cash flows. Even this is easily determined in most cases by consulting one of the rating agencies such as Standard & Poor's that gives a risk rating to a bond (e.g., AA). With the rating in hand, we look in the newspaper and might see that the spread for AA corporate bonds is 1.50% over Treasuries. We then add that 1.50% spread to the corresponding risk-free maturity to get the appropriate discount rate for the bond. Simple.

    This logic was really quite brilliant at the time, and it was soon extended to valuing other, riskier investments. For example, in the 1950s, if Goodyear was considering building a factory, it could be valued in much the same way as a bond. The number of tires that the factory could produce during its useful life could be determined in advance from the plant capacity, and the profit margin from each tire could also be known with some assurance during those relatively stable times. With that information, it would be possible to model the cash flows to be derived from the factory during its life: [(Number of tires per year) x (Useful life of the factory) x (Expected margin per tire)]. The appropriate discount rate to adjust for risk could be determined from the rating given to Goodyear at the time to arrive at the correct spread over the corresponding Treasury rate. With the cash flows and the discount rate in hand, it was possible to arrive at the present value of the factory, which if greater than the cost of the factory provided a positive NPV to the company, leading to the conclusion that the factory should be built. This all makes complete sense and is entirely appropriate in low-uncertainty environments.

  • When NPV does not work: DCF completely unravels when uncertainty rises and the original logic behind using NPV as a valuation methodology falls apart. As uncertainty increases, it becomes impossible to forecast future cash flows and their timing with any degree of confidence. In addition, high uncertainty makes it all but impossible to arrive at the appropriate discount rate. Worse still, the theory behind DCF analysis calls for the discount rate to increase along with uncertainty to adjust for the risk in the investment. The result is that uncertain investments are penalized with very high discount rates that diminish their perceived value. As a result, many interesting opportunities go unexplored because of what could be called "false negatives."Furthermore, the NPV formula reflects only one view of the future. In practice, managers may plug "high," "most likely," and "low" cash flow estimates into the formula to come up with three NPV values. Although this is better than taking one look into the future, it still presumes one unalterable course of action; we start the project and finish the project, which has three different outcomes (high, most likely, and low), and we cannot change direction along the way. NPV cannot effectively account for the value of being able to alter course during the investment implementation effort. There is no way to capture the value of flexibility that would allow for redirection, abandonment, speeding up, slowing down, and so on. Our solution starts by applying OE to harness the upside potential in your business.

In the next chapter, you learn about the underlying principles of OE. Before that, however, we want to stress that OE is not by any means some wild-eyed new theory. It draws off a lot of very solid work done over the years by many scholars who have used approaches such as decision trees, decision and risk analysis (DRA), real options analysis, and scenario analysis. OE's main contribution is to extend beyond these approaches in two ways:

  1. OE does not passively "accept" the parameters of the problem and proceed to valuing the opportunity, but rather challenges you to use the tools and your imagination to reengineer the opportunity and increase its value while driving down the risk. This is particularly valuable as a follow-on to scenario analysis.
  2. The valuation of the opportunity, using the methodology we recommend, allows you to massively reduce the calculative complexity usually associated with DRA and real options approaches.

As this book unfolds, it will become apparent that the OE mindset has applications to almost all areas of business when uncertainty surrounds the outcome of the investment. In particular, OE will be of great value when selecting and managing R&D projects, mergers and acquisitions, and joint ventures and alliances. OE will also prove its value when entering new markets; designing, monitoring, and guiding major contract negotiations; and with strategic planning and scenario planning. How OE impacts these sorts of investments is discussed in detail in Chapter 6, "Applying Opportunity Engineering Throughout Your Business."

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