No Free Lunch: Economics for a Fallen World: Third Edition, Revised

Chapter Sixteen: Valuing the Future - Concepts in Capital & Finance 400 UNCERTAINTY, CASH FLOWS & THE ENTREPRENEUR With our introduction into present value calculations, we are now prepared to expand on the essence of entrepreneurship: navigating the uncertain waters toward the future. Let’s leave aside the interest rate portion of present value and focus on cash flows. This is the heart of the entrepreneur’s problem—to correctly estimate the likely future cash flows of any investment opportunity. While we can use present value calculation to arrive at a value mathematically, we must not fool ourselves. Like any other value, the value of an investment is subjective; it is in the “eye of the beholder.” Ultimately the entrepreneur must make the “best” guess of future cash flows that drive the present value of any investment. That guess is not a stab in the dark; entrepreneurs have a strong incentive to gather market research as to future demand, to carefully scrub the expected costs to the firm, and to make an informed decision. But our use of mathematical financial tools cannot overcome the reality of an uncertain future. It is not a “risky” future that an entrepreneur can simply assign a probability to, such that, on average, he or she will be right. As the economist Ludwig Lachman said, “the future is unknowable, but it is not unimaginable.” Those entrepreneurs that more correctly estimate future cash flows will tend to survive, while those that don’t will tend to lose capital. In many economics and finance texts you may see the “optimal” investment chosen; yet in an uncertain future, investments are at best viable. There is no intellectual basis to suggest they are optimal except in the narrow sense that people make the best decisions they can. As the uncertain future unveils, new knowledge is inevitably gained. This knowledge will lead to revised expectations of future cash flows and a resulting revision in the present value of each investment. This suggests that investments will be regularly reassessed and are subject to cancellation if circumstances change. Is this just ivory tower or does it happen in the real world? In early July 2013, the Washington D.C. city council voted to mandate a “living wage” for businesses coming into the city with greater than 75,000 square feet facilities and over $1B in sales (translation: Walmart). Walmart’s response? They cancelled plans for three new stores in D.C. With the change in policy, Walmart’s expected future cash flows would decrease, making the investment no longer viable. This example illustrates another aspect of present value: the CFs used in the calculation are always net CFs. Net CFs would be the total of all revenues and costs for each period. So in the example with Walmart, it is unlikely that Walmart’s expectations of revenues changed, but their expected costs necessarily increased, driving their net CFs lower. And these CFs are always future oriented; it doesn’t matter the sunk costs of the past that Walmart has already spent in terms of permits, zoning, and previous construction. Present value calculations are necessarily future-oriented; when the expectations of the future change, current valuations must change as well.