Discounted cash flow, rate of return and what really happens.
The standard method for assessing the value of an investment relies on some idea of yield
to redemption or internal rate of return (ROR, IROR). For such an assessment, the future cash flows
from the investment, whether it is a financial instrument or a new factory, are converted
to a present day equivalent value. To do this, future revenues are discounted by some
interest rate to see what they are worth in today's money. Then the plus and minus flows
are balanced off against each other as if they were all in today's money. A big resulting
positive value is good, a small or negative one is bad. In a slightly more subtle form,
the differences between various alternatives (such as: do nothing, project A, project B
etc.) are similarly assessed.
But it doesn't work like that!
Several years of experience doing the corporate standard procedures for capital investment in which the
results were expressed as a rate of return (yield to redemption, the imputed discount rate
that would make the future benefits just match the near-term costs) led to the idea that
reality didn't match the projections.
Desperation and Evangelical Projects
The first observation is that there were two main classes of project proposal. The
class coming from the operations side of the business were of the desperation type:
"If you don't do this we won't be able to continue in business!" . The others
from the marketing side were of the evangelical type: "This opportunity is so good
you can't afford to miss it". Either could be computed to make a high rate of return,
as all involved the differences of large numbers that were not well known and subject to
'estimation' (i.e. guessing). As a result, proposals were massaged to come within an
acceptable range for presentation to the board for sanction. If the rate of return was too
high it wasn't believable and if too low it wasn't acceptable.
Mismatch with Long Term results
It was also obvious that long term corporate results didn't match the rates of return
implicit in the individual projects which collectively had defined the base capital
investment on which the business stood.
A different approach
We assembled a model of the whole business to look at its cash flow as a dynamic
system, this allowed us to inject projects, over a period of time, see the cash flow
consequences they had, not only as individual projects but on the corporation as a whole.
Every real world activity had its reflection in a money flow. We could adjust gearing
(debt vs shareholders equity) and see how the policies would work out over a long time
scale. True, it's only arithmetic, but being able to see graphically the consequences of
policies and choices does help in understanding what is going on.
My experience with problems over these time scales is that people rarely expand their time horizons far enough to see the whole picture. Even if they try, they tend to miss interaction effects and think more in terms of extrapolating, sometimes with statistical models, from the recent past. It's my
(MJMcC) observation that the demographics and the compelling force of reality can be quantified to make a big improvement in perception. You only have to
contact me to get help!