A UK Study on Assumed Cash Flow Conditions and the Application of the Traditional Discounting Cash Flow Model

Abstract

In most of the literature, the discounted cash flow techniques; i.e., NPV and IRR deal with discrete-end-of-year cash flow conditions. However, such a discrete condition would not be justified if several of the cash flow items were realized continuously during the year. The adoption of traditional discounting models may lead to incorrect decisions being made and a more suitable model should be applied based on continuous cash flow conditions. This study examines ( i ) Whether companies consider the differences between continuous and discrete models of discounting, and if so, ( ii ) What the implications that would affect investment decision outcomes are. The findings of a survey of the largest 250 UK quoted companies have highlighted the following results. Firstly, 88% of companies having projects with continuous cash flows applied discrete discounting models, and this implies that incorrect investment decision have being made. Secondly, the majority of decision-makers are able to recognize the flaw in their using of the traditional discrete discounting models. Thirdly, 62% of companies are recognizing significant differences between discrete and continuous discounting models, and these differences are greatest for projects that have an economic life of up 20 years, large values of discount rate, and where the cash flows are realized in the early years of project life. Finally, 58% of companies stated that they were willing to change their decisions to follow the continuous models of discounting as a result of the difficulty in obtaining accurate outcomes from the ill fitting discrete discounting models.

Keywords: UK companies, capital budgeting, NPV, IRR, discounted cash flow techniques, discrete cash flow, continuous cash flow, continuous discounting

JEL Classification: G31, G30, M41, M20