Summary by Jose M. Luis
Master of Accountancy Program
University of South Florida, Fall 2000
Current situation: The standard net present value (NPV) analysis method evaluates an investment assuming that existing conditions will continue into the future.
Problem: This is a static model that cannot provide the information required to make sound investment decisions.
Solution: Use the moving baseline1 approach which, by incorporating a non-investment forecast, provides a dynamic analysis that can improve management decision-making.
NPV Analysis – Calculated by adding the present value (PV) of future cash returns, discounted at the minimum rate of return. This sum constitutes the value of the project. It’s a four-step procedure:
Estimate the net future cash returns associated with the project.
Determine the PV of the net future cash returns.
Estimate the PV of the cash outlay necessary to implement the proposed project.
Compare the PV of the expected returns with the PV of the cash outlay.
Major fallacy of NPV analysis and its effects:
In Step 1, the commonly used NPV model evaluates cash flows against present industry and firm conditions.
It assumes those conditions will remain constant throughout the projected life of the asset or project.
However, if new equipment is not purchased, the present equipment will not continue to produce at a constant level, but at reduced efficiency. Repair and maintenance costs increase. Cost of lost production from down-time.
If the firm doesn’t initiate innovative projects, competitors will (perhaps changing the competitive nature of the industry).
When firms compare numbers generated by NPV method with existing conditions, new technology appears to cost too much, in return for only minor improvements in cash flow.
But if a competitor invests in new technology, the comparison cannot be made with the status quo: the firm must assume that its own cash flow will decline.
The moving baseline
Evaluates investment decisions by comparing the financial outcome of investing with the financial impact of not investing.
Requires that an estimate of the non-investment decision also be made.
The estimate of the non-investment cash flow becomes the moving baseline.
Non-investment decisions usually result in decreased NPV due to wear & tear of equipment or inability to meet competitors on quality, delivery or cost.
Estimating the moving baseline cash flows:
Estimate future cash flows for a proposed investment given the current operating conditions.
Estimate the increased expenses and/or the decreased revenues of not investing.
Combine the estimates by adding avoidance of increased expense or decreased profit to the cash flows generated by the proposed investment.
PV capital expenditure analysis is a tool to help managers make sound investment decisions.
By adding the moving baseline concept, the tool is improved, but it is still a tool, based on estimates that are themselves based on uncertainties.
Estimating future cash flows due to non-investment decisions is a forecast. The best you can get is an educated estimate concerning competitors’ behavior and the effect that competitors’ potential decisions will have on the marketplace.
Worst-case, most-probable, and best-case scenarios can be developed to let management see the range of possible outcomes.
The final decision rests with management, regardless of analysis outcomes.
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