Watch for pitfalls of discounted cash flow techniques

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

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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.

Whether using nominal or constant dollars (appropriately matched to nominal or "real" cost of capital), a manager still must estimate a project's future cash flows. But applying an expected inflation factor to a project's net cash flow is not enough because inflation does not affect all cash flow components equally. Some cash flows, such as the cost of replacing surgical supplies, adjust completely with inflation, while others may adjust partially or not at all.

For taxable organizations, a major source of future benefits from an investment lies in a depreciation tax shield. Because depreciation charges must be based on original cost rather than replacement cost, they are unaffected by inflation. Cash flows associated with long-term commitments (such as many lease payments, fixed-rate borrowing, and multi-year, fixed-price purchase or sales contracts) also tend not to change with inflation. These complexities imply that managers should explicitly consider inflation's effects on different components of a project's cash flows.

RISK ADJUSTMENTS. Surveys of practice(g) indicate that many manufacturing firms adjust for project risk by increasing the discount or hurdle rate applied to a project's future cash flows. Less often realized is that"... using a single risk-adjusted discount rate implies an important and somewhat special assumption about the risk associated with future cash flow estimates: [that] such risks increase geometrically with chronological distance from the present."(h)

For an organization with a nominal cost of capital of 10 percent considering a three-year project with an imposed 5 percent risk premium, the discount rate applied to this project's future cash flows would be 15 percent. Exhibit 3 shows the project's present value factors with and without the risk adjustment over three years.

In year one, the difference of 0.0395 is about 4.3 percent of the present value factor without the risk premium ([0.0395/0.9091] = 0.043) By year three, not only would the difference increase to 0.0938, but it also has increased to about 14 percent of the present value factor without the risk premium ([0.0938/0.6575] = 0.1427).

The reason for this geometric increase is that the risk premium also is applied to the non-risk-related portion of the discount rate. The further along in a project's term, the greater the cumulative effect of compounding.

This can be illustrated by a breakdown of the denominators of the present value factors for year two. In the absence of the risk premium, this is 1.1 x 1.1. The present value factor for year two without the risk premium, 0.8264, is calculated as [1/(1.1 x 1.1)]. If the risk premium is included, the present value factor is [1/(1.15 x 1.15)], which expands to: