Effect of cost structure and demand risk in the justification of new technologies

This paper sets out a framework for financially evaluating new manufacturing technologies. Existing capital budgeting procedures typically use discounted cash flow techniques (DCF) which do not consider the differences in risk of different technologies. Although there are many factors that affect the risk of technology, this paper focuses on two: the effect of the cost structure and the effect of demand variability on the risk of the technology. The relationship between cost structure and risk is important for new technologies because the authors show that these technologies may have different cost structures than conventional technologies. New technologies may cost more to acquire and install, but may have lower fixed yearly operating costs and lower unit variable costs than conventional systems. It is shown that the risk of technology investment is related to its operating costs through the breakeven ratio, the yearly production volume necessary to cover fixed operating costs. The present evidence indicates that new technologies have a lower breakeven point than conventional technologies. A major result is that the technology’s risk declines as the breakeven point declines or as the correlation between the firm’s demand and stock market declines. This indicates that new technologies could be less risky than conventional technologies, and a lower discount rate should be used in DCF calculations. When it is appropriate to justify an investment solely on the basis of cost, financial justification can be done in three ways: discounting cash flows involving both revenues and costs, total costs, or cost savings. Each method uses a different discount rate, and the discount rate for total cost or cost savings methods is often lower than the discount rate involving both revenues and costs.