Inclusion of flexibility benefits in discounted cash flow analyses for investment evaluation: A simulation/optimization model

Abstract

It has been argued that conventional discounted cash flow (DCF) techniques, which are commonly used for investment justification, are inadequate and may even be inappropriate for the justification of advanced manufacturing systems whose strategic value comes from such attributes as flexibility. The problem lies in the proper estimation of the value of flexibility in financial or cash flow terms, so that the DCF techniques, which are otherwise conceptually sound, become relevant. This involves an assessment of the value of the flexibility of the manufacturing system in dealing with the uncertainties in its operating environment. We propose a simulation-optimization methodology for this assessment in cash flow terms and use it in a DCF framework. We use simulation to generate the environmental parameters in each period of an appropriate evaluation horizon. We develop a mathematical programming model to determine the distribution of the possible net revenues of the system in each period by capturing the combined effect of the different types of flexibilities that the manufacturing system may possess. We illustrate the application of our methodology using numerical examples and discuss how it can be used to assess the value of flexibility in cash flow terms. We show that our approach facilitates the justification of capital investment in advanced manufacturing systems which tend to get undervalued under the traditional DCF approaches. It would also help managers address such important questions as “how much incremental investment should we be willing to make now for the additional flexibility features?” and “does the expected present value of the future benefits of added flexibility justify the incremental capital investment now?” In essence, our paper addresses the question as to appropriate techniques or approaches for justifying proposed strategic investment decisions.