Some observers of capital budgeting practices have cited examples of how capital budgeting techniques have not been properly utilized [Note: One of the First is found in Robert H. Hayes and David Garvin, “Managing As If Tomorrow Mattered”, Harvard Business Review, pp. 70–79]. That is, despite the evidence that more firms are using NPV, that does not mean that the right decisions about investment opportunities are being made. The examples cited have focused on the failure of capital budgeting techniques to evaluate the acquisition of new technological equipment and information management projects. I believe that if properly employed—that is, good cash flow estimation capturing all the benefits and costs that can be realized from introducing a new technology, and the proper estimation of an appropriate discount rate—these techniques can help identify opportunities available from new technologies.
In this post, I am going to overview failure of capital budgeting on new technological equipment and information management project acquisition [a justification]. Read on…
When new technological equipment, such as a newly created computer-aided production process, is considered for acquisition, the cash flows must be estimated. Does management do a good job of estimating the potential benefits from such technologies? Informed observers believe that this may not be the case despite the widespread use of capital budgeting techniques.
For example, a survey conducted as part of a Boston University roundtable almost 20 years ago found that 78% of the respondents felt that:
Most businesses in the U.S. will remain so tied to traditional quantitative investment criteria that they will be unable to properly evaluate the potential of computer-aided manufacturing options [Note: As cited in Robert S. Kaplan and Anthony A. Atkinson, Advanced Management Accounting (Englewood Cliffs, NJ: Prentice hall, 1989), p. 474].
Despite the passing of time since this survey, observers believe that the situation has not improved.
It has been observed that those making capital budgeting decisions fail to (or refuse to) take into consideration critical factors that may improve future cash flow as a result of the introduction of a new technology. Keep in mind; this is not simply replacing one type of equipment with a technologically slightly superior one. Rather, the focus here is on new technologies that will significantly alter the production process. Not only is the impact on the future cost structure of the firm important, but the potential impact on its competitive position—domestic and global—must be assessed.
Underestimating the potential benefits when projecting cash flows results in a bias in favor of rejecting a new technology. But there are more problems. The estimated cash flows must be discounted. In my personal view, it is not uncommon for firms to select a very high required return to evaluate new technologies. Of course, there is nothing wrong with using a high required return if the analysis demonstrates that such a return is warranted [Note: There is nothing wrong with assigning a high discount rate to a project involving new technologies, but, this discount rate should reflect the project’s risk, considering the benefits that the project may provide in terms of diversification. If the project has high stand-alone risk but low risk once the project is viewed in terms of the entire company as a portfolio of projects, a high discount rate is not justified]. However, for some firms the analysis underlying the setting of a high required rate ranges from little to none; or, put another way, for some firms the high required rate is arbitrarily determined.
Why does a high required return (or, equivalently, discount rate or hurdle rate) bias the acceptance of new technologies?
Recall our old friend the time value of money. We know that the further into the future the positive cash flows, the lower will be all of the discounted low measures. We also know that the higher the discount rate the lower the NPV and profitability index (Note: In the case of the IRR, it will have to exceed the high hurdle rate).
Now consider a typical new technology that is being considered by a firm. It may take one or more years to get the new technology up and running. Consequently, positive cash flow may not be seen for several years. A high discount rate coupled with positive cash flows not coming in for several years will bias the decision in the direction of rejecting a new technology. For example, suppose a discount rate of 22% is required on a project and that a positive cash flow is not realized for at least four years. Then the present value of a positive cash flow of $1 four years from now at 22% is $0.45; for a positive cash flow of $1, 10 years from now, the present value is $0.14. However, if the correct discount rate is, say, 13%, then the present value of a $1 positive cash flow would be $0.61 if it is received four years from now and $0.29 if it is received 10 years from now.
You can see the dramatic impact of an unwarranted high discount rate. Add to this the underestimation of the positive cash flows by not properly capturing all the benefits from the introduction of a new technology, and you can see why U.S. firms may have been reluctant to acquire new technologies using state-of-the-art capital budgeting techniques. Is it any wonder that respondents to a study conducted by the Automation Forum found that the financial justification of automated equipment was the number-one impediment to its introduction into U.S. firms two decades ago? [reference: Sandra B. Dornan, “Justifying New Technologies”, (July 1987)].
In addition to the possible understatement of future cash flows or the overstatement of the discount rate associated with investment projects employing new technology, there is the potential problem of ignoring the real options that are present in these types of projects.
A real option is an option associated with an investment project that has value arising from the option the company possesses, for example, to defer investment in the project, abandon the project, or expand the project. It may be the case that the new technology that provides a comparative or competitive advantage is unique, patented technology. If this is the case, the company may have a real option to defer investment, which enhances the value of the project beyond the value attributed simply to discounted cash flows [Note: For an example of a real option analysis in the case of information technology, read: Michel Benaroch and Robert J. Kaufman, “A Case for Using Real options Pricing Analysis to Evaluate Information Technology Project Investments,” Information Systems Research 10, No. 1, (1999), pp. 70–86]. According to survey evidence, less than 30% of CFOs incorporate the value of these real options in the capital budgeting decision [Reference: Graham and Harvey, “How Do CFOs Make Capital Budgeting and Capital structure Decisions?”].
Total Cost Ownership [Total Cost Operation] – The Gartner Group
In fact, because of the failure to recognize the wide-ranging impact of the acquisition of new technologies, The Garnter Group in the 1980s proposed the concept of Total Cost Ownership (TCO). This measure, sometimes also referred to as “the Total Cost of Operation”, is used to evaluate the direct and indirect impact related to the acquisition of new capital investment, taking into account all economic costs beyond the purchase cost and all the potential benefits.
These economic costs include in addition to the acquisition costs changes in operating costs, conversion costs, and the cost of training personnel on the new equipment. On the benefit side, avoiding the potential loss of reputation from say security breaches or an improved risk management system are recognized as well as any productivity or performance improvements.
Basically, if all costs and benefits are properly accounted for in the capital budgeting framework set forth, the same conclusions about acquiring new technologies as obtained from TCO analysis will be reached. It has been the failure of those employing traditional capital budgeting to take into account the not-so-obvious costs/benefits of ownership in acquiring new equipment, particularly new technologies, that TCO highlights, making it a popular tool employed by decision makers.
Still, despite the best efforts of management, it may be difficult to quantify the value of new technology and therefore difficult to use traditional capital budgeting techniques or TCO. For example, in evaluating technologies for managing risk it is not simple to quantify the benefits. A 2003 Federal Bureau of Investigation (FBI) report based on a survey of 241 firms, for example, stated that three-quarters of the survey participants acknowledged financial loss from security breaches of different types. However, of those firms that acknowledged losses, only 47% could quantify the loss [reference: “2003 CSI/FBI Computer Crime and Security Survey”, Computer Security Institute, 2003, p. 20].
One approach to deal with acquisitions when financial measures are difficult to quantify that gives recognition to important factors other than cash flows, is the balanced scorecard approach. Another approach to deal with the competitive impact of capital budgeting decisions is the treatment of these decisions within the context of option theory.
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