Abstract
Uncertainty influences a decision maker's choices when making sequential capital investment decisions. With the possibility of extremely negative cash inflows, firms may need to curtail operations significantly. Traditional Net Present Value analysis does not allow for efficient management of these problems. In addition, firm managers may behave irrationally by accepting negative Net Present Value projects in the short term. This paper presents a Monte Carlo simulation based model to provide policy insights on how to incorporate extreme cash flows and manager irrationality scenarios into the capital budgeting process. This paper presents evidence that firms with irrational managers and experiencing extremely negative cash flows may, under certain conditions, reap long term rewards associated with the acceptance of negative Net Present Value projects in the short term. These benefits are largest if cost ratios (discount rates) are small, or investment horizons are high. We argue that acceptance of short term negative Net Present Value projects implies the purchase of a long term real option which can generate positive long term cash flows under certain conditions.
Highlights
Three important factors, namely, sunk cost, risk and the option to shutdown, influence corporate decision making regard capital investments
The 1997 Asian financial crisis and the 2008 global subprime crisis have forced firms to consider that the unpleasant impact of major negative shocks1, can make a profitable project turn sour and render traditional net present value (NPV) analysis less effective
Given the paucity of academic papers addressing both types of extreme scenarios (ECFs and the presence of aggressive managers) simultaneously, we develop a simulation-based model that accommodates both scenarios within a traditional framework
Summary
Three important factors, namely, sunk cost, risk and the option to shutdown, influence corporate decision making regard capital investments. Under extreme cash flow (ECF) conditions, the tendency to continue investments in negative NPV projects can increase firm losses because of possible simultaneous compounding of agency and information asymmetry problems. The message here is that if managers take short-term risks (as an aggressive manager would), or face an extreme/ unexpected catastrophic loss situation, they have two choices They can continue with the unprofitable project, or terminate it. Given the paucity of academic papers addressing both types of extreme scenarios (ECFs and the presence of aggressive managers) simultaneously, we develop a simulation-based model that accommodates both scenarios within a traditional framework Using this model, we attempt to provide simulation-based answers to the following questions: Does a firm benefit from continuing to invest in projects unprofitable in the short term? We attempt to provide simulation-based answers to the following questions: Does a firm benefit from continuing to invest in projects unprofitable in the short term? Should firms tolerate managers who are predisposed to assuming greater risks? Will their persistence with projects unprofitable in the short run pay off in the long run? Will the possibly of extreme cash flows influence these results?
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