Capital Budgeting and Initial Cash Outlay (ICO) Uncertainty

Financial Decisions, Vol.18, No.1, pp. 1-16, Summer 2006

16 Pages Posted: 11 Feb 2011 Last revised: 17 Apr 2018

See all articles by Michael Ehrhardt

Michael Ehrhardt

University of Tennessee, Knoxville - Department of Finance

John M. Wachowicz

University of Tennessee - Knoxville

Date Written: February 10, 2005

Abstract

According to recent surveys, most companies use discounted-cash-flow (DCF) methods to evaluate capital budgeting decisions. DCF methods typically assume that a project’s initial cash outlay (ICO) is known with certainty. However, many types of initial outlays have substantial uncertainty, especially those involving the construction of a new facility. This risk affects not only the ICO, but it also affects subsequent depreciation tax shields. A proper capital budgeting analysis should incorporate the additional risk that is due to an uncertain ICO. We show that neither the typical practices employed by corporations nor two common techniques advocated in the finance literature, risk-adjusted discount rates and certainty equivalents, satisfactorily address ICO risk. Sensitivity analysis is an effective way to address ICO risk, but the finance literature often overlooks the adjustments needed to satisfactorily address ICO risk within a sensitivity analysis. We fill this gap in the literature by showing the impact of ICO risk on the standard deviation of a project’s NPV. We then apply sensitivity analysis with the appropriate adjustments in a numerical example to illustrate the impact of ICO risk.

Keywords: Discounted cash flow (DCF), net present value (NPV), initial cash outlay (ICO), sensitivity analysis

JEL Classification: G30, G31

Suggested Citation

Ehrhardt, Michael and Wachowicz, John M., Capital Budgeting and Initial Cash Outlay (ICO) Uncertainty (February 10, 2005). Financial Decisions, Vol.18, No.1, pp. 1-16, Summer 2006, Available at SSRN: https://ssrn.com/abstract=1759535

Michael Ehrhardt

University of Tennessee, Knoxville - Department of Finance ( email )

Knoxville, TN 37996
United States

John M. Wachowicz (Contact Author)

University of Tennessee - Knoxville ( email )

Knoxville, TN 37996
United States
865-974-1729 (Phone)

HOME PAGE: http://web.utk.edu/~jwachowi/wacho_hp.htm

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