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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
Scott P. Dulman
Affiliation:
Scott P. Dulman is a manager of strategic planning forBell Atlantic Enterprises.
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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
Information
Business History Review , Volume 63 , Issue 3 , Autumn 1989 , pp. 555 - 587
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

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

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

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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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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.

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

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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.

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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.

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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): 390–418Google 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, 24–30Google Scholar; Kaplan, “Must CIM Be Justified by Faith Alone?“

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