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The Development of Discounted Cash Flow Techniques in U. S. Industry

Published online by Cambridge University Press:  13 December 2011

Scott P. Dulman
Affiliation:
Scott P. Dulman is a manager of strategic planning forBell Atlantic Enterprises.

Abstract

This article supplies a missing piece in the story of the growth of managerial technology—the development of discounted cash flow techniques for projecting the profitability of capital budgeting alternatives. The article traces the origins of these methods in the industrial sector to the early work of railroad locating engineers and describes the refinement of DCF practices by AT&T and chemical firms. It concludes with a discussion of the diffusion of this analytic tool through the interaction of practicing engineers, consultants, professional associations, and scholarly publications.

Type
Articles
Copyright
Copyright © The President and Fellows of Harvard College 1989

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References

1 Chandler, Alfred D., The Visible Hand: The Managerial Revolution in American Business (Cambridge, Mass., 1977), 445.Google Scholar

2 The present value concept that will be discussed in this article may be defined by the equation:

V = ΣtXt(l + r)−t

where

Xt = cash flow in period t (including initial capital outlay)

r = discount rate

t = number of years or periods

V = present value

3 Chandler, Alfred D. Jr, Strategy and Structure: Chapters in the History of the American Industrial Enterprise (Cambridge, Mass., 1962)Google Scholar; Chandler, , “The Emergence of Managerial Capitalism,” Business History Review 58 (Winter 1984): 473503.CrossRefGoogle Scholar

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5 Wellington, Arthur M., The Economic Theory of the Location of Railways (New York, 1877), 193–97, quotation on 194.Google Scholar

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7 Ibid., 192–95.

8 Ibid., 2d ed. (1887).

9 Ibid., 7.

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15 Johnson and Kaplan, Relevance Lost, chap. 4.

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17 Brown, “Pricing Policy,” 197.

18 Johnson and Kaplan, Relevance Lost, chap. 5.

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29 Public utility regulatory requirements did not affect the utilization and diffusion of modern capital budgeting practices. The use of AT&T's present worth methods was not discussed during the House of Representatives investigation of the telephone industry, according to the transcripts in U.S. Congress, House, Investigation of the Telephone Industry in the United States, 76th Cong., 1st Sess., 1939, H. Doc. 340. I did not find references to dis counted cash flow concepts in the literature on the history of public utility regulation prior to the Second World War. References to the economic history of public utility regulation include Bonbright, James C., Principles of Public Utility Rates (New York, 1961)Google Scholar; and Phillips, Charles F. Jr, The Economics of Regulation: Theory and Practice in the Transportation and Public Utility Industries (Homewood, Ill., 1969).Google Scholar

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Commercial surveys were described in Charlesworth, “General Engineering Problems of the Bell System,” 515–41; and Rice, “Applications of Fundamental Plans.” Engineering cost studies were described in Rhodes, “Engineering Cost Studies,” 1–14; E. N. Renshaw, “Comparative Cost Studies and Estimates,” The Bell System Building and Equipment Conference, Dec. 1925, section 7.

33 “Annual Report—Engineering Department,” American Telephone and Telegraph Co. (1906), 6–7.

34 Rice, “Application of Fundamental Plans,” 546.

35 Charlesworth, “General Engineering Problems of the Bell System,” 515–41; Rhodes, “Engineering Cost Studies,” 1–14; Rhodes, , “Engineering Cost Studies,” Telegraph and Telephone Age 15 (1 Aug. 1926): 339–44.Google Scholar

36 Rhodes, “Engineering Cost Studies,” 1 Aug. 1926, 341.

37 Engineering Economy, AT&T Co., Department of Operations and Engineering (1952).

38 J. C. Gregory, letter to author, 10 May 1984.

39 Ibid., confirmed in letter to author, 22 March 1984 from Claude O. Goldsmith, senior vice-president of finance at Atlantic Richfield.

40 Gregory's tables were based on Naperian logarithms:

where

Xt = cash flow in period

r = discount rate

t = number of years or periods

V = present value

e = base of Naperian logarithms

See J. C. Gregory, “Interest Rate Tables for Determining Rate of Return on Profit Projects,” Atlantic Refining Co., internal document, 1946.

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42 William McEachron, letter to author, 6 April 1983.

43 James Weaver, letters to author, 11 Nov. 1983 and 15 Feb. 1984. Atlas Powder originated as one of two Du Pont operations (Hercules Powder was the second) divested in 1912 under a federal antitrust agreement.

44 Weaver, James B., “Use of Engineering Economics by the Chemical Industry,” Engineering Economist, Fall 1956, 1925CrossRefGoogle Scholar; Weaver, James and Reilly, Robert, “Interest Rate of Return for Capital Expenditure Evaluation,” Chemical Engineering Progress, Oct. 1956, 405–12.Google Scholar

45 Weaver, “Use of Engineering Economics by the Chemical Industry,” 22.

46 Terborgh, George, Dynamic Equipment Policy (New York, 1949).Google Scholar

47 Robert Kaplan used arguments that were similar to Terborgh's in his article on justifying the acquisition of computer-integrated manufacturing (CIM) equipment; he advised managers to focus on their ability to estimate the costs and benefits of CIM. See Kaplan, Robert S., “Must CIM Be Justified by Faith Alone?Harvard Business Seview 64 (March-April 1986): 8795.Google Scholar

48 Terborgh, Dynamic Equipment Policy, chaps. 6 and 7.

49 Lutz, Friedrich and Lutz, Vera, The Theory of Investment of the Firm (New York, 1951).Google Scholar

Their formula is:

r = instantaneous rate of interest

Q(t) = rent on equipment at period t

S = scrap value

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Present Value

50 Ibid., chap. 2.

51 Lorie, James H. and Savage, Leonard J., “Three Problems in Rationing Capital,” Journal of Business 28 (Oct. 1955): 229–39.CrossRefGoogle Scholar The internal rate of return method is applied to capital budgeting problems as follows:

Xt = cash flow of period t

i = time value of money to the firm

r = internal rate of return (IRR)

n = life of investment

solve for r in order to calculate the IRR

52 Bierman, Harold and Schmidt, Seymour, The Capital Budgeting Decision, 6th ed. (New York, 1984)Google Scholar; chap. 3 compares the IRR and NPV methods.

53 Dean, Joel, Capital Budgeting (New York, 1951).Google Scholar

54 Ibid., 17.

55 Gordon Shillinglaw, professor at Columbia University, Graduate School of Business, interview with author, December 1983. Confirmed in letter to author from John M. Schultz, 10 May 1984. Schultz worked for Horace Hill at Atlantic Refining and was promoted to controller of Atlantic's chemical subsidiary in 1966; he later became controller of the Alaskan pipeline project.

56 Hill, A New Method of Computing Bate of Return on Capital Expenditures; Dean, Joel, “Controls for Capital Expenditures,” AMA Financial Series (New York, 1953): 313Google Scholar; Gordon Shillinglaw, “Measuring the Investment Worth of Capital Projects,” ibid., 14–23; Hill, “Projecting Future Effects of Capital Expenditures,” ibid., 31–36; Dean, Joel, “Measuring the Productivity of Capital,” Harvard Business Review 32 (Jan.-Feb. 1954): 120–30Google Scholar; Dean, , “Has MAPI a Place in a Comprehensive System of Capital Controls?Journal of Business 28 (Oct. 1955): 261–74CrossRefGoogle Scholar; Shillinglaw, “Residual Values in Investment Analysis,” ibid., 275–84.

57 Anthony, Robert N., Shoe Machinery: Buy or Lease?, rev. ed. (New York, 1955).Google Scholar

58 Ibid., 13.

59 Anthony, Robert N., Management Accounting: Text and Cases (Homewood, Ill., 1956), chaps. 17 and 18.Google Scholar

60 Christenson, Charles, “Construction of Present Value Tables for Use in Evaluating Capital Investment Opportunities,” Accounting Review 30 (Oct. 1955): 666–72.Google Scholar

61 United States vs. United Shoe Machinery Company, 222 Fed. Rep. 350, 12n, 56, 56n; United States vs. United Shoe Machinery Company, 234 Fed Rep. 127, lOn, lln., U.S. vs. USMC 110 F. Supp. 295, 301, 301n.

62 “Sales Prices for Outstanding Shoe Machinery: A Basis for Negotiation,” Andrews, Anthony, and McLean, internal document, May 1955; “Determination of Customer Equivalent Optional Sale Prices for Machines Outstanding on Form B Leases,” Joel Dean Associates, internal document, April 1956.

63 Dutton, Thomas, and Butler, “The History of Progress Functions as a Managerial Technology,” 204–33.

64 Dutton, Thomas, and Butler concluded that social costs can be incurred when applied studies and management practices diverge from theoretical research and empirical studies. Robert S. Kaplan emphasized the importance of cooperation between researchers and industrial managers in the development and adoption of innovative management accounting practices. See Dutton, Thomas, and Butler, “The History of Progress Functions as a Managerial Technology,” 204–33; and Kaplan, Robert S., “The Evolution of Management Accounting,” Accounting review (July 1984): 390418Google Scholar; Johnson and Kaplan, Relevance Lost, 253–63.

65 Some recent publications on capital budgeting challenges and innovations include Brealey, Richard A. and Myers, Stewart C., Principles of Corporate Finance, 2d ed. (New York, 1984), chap. 34Google Scholar; Hendricks, James A., “Cost Accounting for Factory Automation,” Management Accounting, Dec. 1988, 2430Google Scholar; Kaplan, “Must CIM Be Justified by Faith Alone?“

66 Hendricks, “Cost Accounting for Factory Automation,” 25.