Inclusion of flexibility benefits in discounted cash flow analyses for investment evaluation: A simulation/optimization model |
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| Affiliation: | 1. M.J. Neeley School of Business, Texas Christian University, Fort Worth, TX 76129, USA;2. College of Business Administration, University of North Texas, Denton, TX 76203, USA;1. Section of Pulmonary, Critical Care and Sleep Medicine, Yale University School of Medicine, Yale University, New Haven, CT;2. Division of Pulmonary, Allergy, and Critical Care Medicine, Perelman School of Medicine, University of Pennsylvania, Philadelphia, PA;3. Department of Radiology, Perelman School of Medicine, University of Pennsylvania, Philadelphia, PA;4. Department of Pathology and Laboratory Medicine, Perelman School of Medicine, University of Pennsylvania, Philadelphia, PA;5. Center of Excellence in Environmental Toxicology, Perelman School of Medicine, University of Pennsylvania, Philadelphia, PA;6. Cartographic Modeling Laboratory, Perelman School of Medicine, University of Pennsylvania, Philadelphia, PA;7. Department of Biostatistics and Epidemiology, Perelman School of Medicine, University of Pennsylvania, Philadelphia, PA;8. Division of Pulmonary, Critical Care, Allergy, and Sleep Medicine, University of California, San Francisco, San Francisco, CA;9. Department of Medicine, Rutgers Biomedical and Health Sciences University, New Brunswick, NJ;10. Division of Pulmonary, Allergy, and Critical Care Medicine, University of Pittsburgh School of Medicine, Pittsburgh, PA;1. Department of Accounting, University of Texas at San Antonio, San Antonio, TX 78249, United States;2. School of Business Administration, University of Houston-Victoria, Victoria, TX 77901, United States;1. Department of Cardiology, Boston Children''s Hospital, Harvard Medical School;2. Division of Cardiology, Brigham and Women’s Hospital, Harvard Medical School, Boston, Massachusetts;3. Department of Pediatric Cardiology, Children’s Hospital of Wisconsin, Medical College of Wisconsin, Milwaukee, Wisconsin;4. Ahmanson/University of California Los Angeles Adult Congenital Heart Disease Center, Los Angeles, California;5. Department of Pathology;6. Division of Gastroenterology, Brigham and Women’s Hospital, Harvard Medical School, Boston, Massachusetts;1. Liverpool John Moores University (LJMU), Faculty of Engineering and Technology, Department of the Built Environment, Byrom Street, Liverpool L3 3AF, United Kingdom;2. Zurich University of Applied Sciences (ZHAW), Department Life Sciences and Facility Management, Institute of Facility Management, Grüental, 8820 Wädenswil, Switzerland;3. Leegionella Ltd., Registered Office, 5 Ribblesdale Place, Preston PR1 8BZ, United Kingdom;4. Hygieneinspektionsstelle für Trinkwassersysteme, Hauptring 35, 04519 Rackwitz, Germany |
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| 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. |
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