Pitfalls in Evaluating Risky Projects

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Pitfalls in Evaluating Risky Projects
James E. Hodder and Henry E. Riggs
In recent years, the leaders of American companies have been barraged with attacks on their investment policies. Critics accuse American executives of shortsightedness and point out that managers in Japan and Europe often fix their vision on more dis¬tant horizons. Here, it is claimed, managers pay too much attention to quarterly earnings reports and not enough to such basic elements of industrial strength as research and development. Some analysts see the root of this problem in the tendency of American companies to rely on discounted cash flow tech¬niques in weighing long-term investments.1 These critics argue that DCF techniques have inherent weaknesses that make them inappropriate for evalu¬ating projects whose payoffs will come years down the road. We disagree with the contention that DCF tech¬niques are inappropriate for evaluating long-term or strategic investment proposals. We do believe, how- Mr. Hodder is assistant professor of industrial engineering and engineering management at Stanford University. His teaching and research have focused on capital budgeting and international hedging decisions. Mr. Riggs is professor of industrial engineering and engineering management and vice president for development at Stanford University. Before joining the university in 1974, he worked for 15 years in industry in various financial positions. Riggs is the author of many publications on accounting and fi¬nance and of the recent book. Managing High-Technology Compa¬nies (Belmont, California, Lifetime Learnings Publications, a division of Wadsworth, Inc., 1983). I. See for example, Robert H. Hayes and David A. Garvin, "Manag¬ing as if Tomorrow Mattered," HBR May-June 1982, p. 71. ever, that companies often misapply or misinterpret DCF techniques. Misuse is particularly serious in evaluating long-term capital investments, such as ambitious R&D projects, that appear to involve high risk. Misapplication of DCF techniques can certainly contribute to an unwarranted aversion to making long-term investments. However, the problem lies not in the technique but in its misuse. Money has a time value in every economy, and cash is the life-blood of every business. To evaluate cash flows (costs or revenues) generated in different periods requires a procedure for making comparisons. For evaluating and ranking investment proposals, whether they have short or long lives, and involve capital equip¬ment, R&X), or marketing expenditures, we need techniques that recognize that cash flows occur at different times. Discounting provides a rational and conceptually sound procedure for making such eval¬uations. Unfortunately DCF techniques, like computers, can yield impressive-looking but misleading outputs when the inputs are flawed. Managers with biased assumptions may end up with biased conclusions. The fault, however, lies not with the technique but with the analyst. The path to improved capital bud¬geting requires education in the proper use of rational techniques rather than their rejection out of hand. In our view, DCF techniques provide valuable in¬formation to assist management in making sound investment decisions. We emphasize the word assist Copyright © 1984 by the President and Fellows of Harvard College. All rights reserved. because it is people, rather than analytical tools, who make decisions. Managers may have many objectives and face many constraints in their decision making. Nevertheless, they need information on the relative financial merits of different options. Properly em¬ployed, DCF techniques provide such information. The alternative is to ignore the time value of money and implicitly assume that, for example, a dollar earned ten years from now will have the same value as a dollar today. DCF procedures, as commonly applied, are subject to three serious pitfalls: Improper treatment of inflation effects, particularly in long-lived projects. Excessive risk...
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