I'm glad you've agreed to join me on this course. In this lesson, we're going to take a fresh approach to developing assumptions that will underpin our capital budget. Let's talk about what goes into a capital budget. Capital budgets ultimately hinge on two things, a forecast of future cash flow and a discount rate. The forecast of future cash flow is an estimate of the cost offset by an estimate of the revenues. Timing is important because cash flows in the earlier years get weighted more heavily then cash flows in the later years.
The traditional capital budgeting approach is to develop an expectation of a single future outcome. What we are going to explore more in this section is developing an approach to better understand the range of possible outcomes. The very first step to evaluating the opportunity To identify all of the key uncertainties that potentially impact shareholder value. One tool you can use to facilitate this discussion is called an influence diagram. And influence diagram is a map of the uncertainties and their relationships to one another. Often there are some uncertainties that impact one or more of our assumptions.
To read this diagram, we will start with our objective and for most profit oriented companies, the objective is to maximize shareholder value. This is the purpose of capital budgeting. Then we need to calculate shareholder value, which is quite simply revenues minus costs less any upfront capital we need to expend to pursue the opportunity. Next, we determine all of the assumptions that feed into the calculations of these amounts. Now, most of the assumptions have a degree of inherent uncertainty. And as a result, we should be thinking of these uncertain assumptions in terms of a potential range of outcomes as opposed to say a point estimate.
Finally, we have an operating plan that dictates how we intend to initiate the opportunity. These decisions will drive assumptions, but they won't resolve the inherent uncertainty. Let's see how you deal with setting an uncertain assumption. Take a moment to ponder this question. How many egg laying hens are there in the world today? You've got five different answers to consider and keep in mind that we have something like 7 billion people in the world and chicken products are the most common sources of protein.
What do you think? Have you got an answer yet? Okay, let's take a look at the real answer. The correct answer is actually 4.93 billion egg laying hens at last count I have no idea who is actually doing this count. But for argument's sake, let's just pretend that's the right number. Now unless you happen to be that person who counted all 4.93 billion hens, you probably didn't have much of an answer, which is why D happens to be the most appropriate answer.
A happens to be a point estimate. And while many of us would like to predict the future with some degree of precision, we should know intuitively that that is impossible. The B and the C answers have approximately associated with them. But what is approximately is that plus or minus 5%, or 10%. This helps us with defining uncertainty But once again, really doesn't get at the idea of setting any boundaries. Now answer he provides us with a range but relatively speaking, it's a rather narrow range, which suggests we are still trying to get at most estimate of a highly uncertain number.
Only answer D embraces the uncertainty and recognizes the fact that probably most of us are not checking experts. Thus, if we want to be highly confident in our response, we should provide a rather wide range of potential outcomes. If this turns out to be a highly material assumption to our business case, we might want to hire a chicken expert to narrow that range down. But if it turns out that we are only really interested in something else, and the number of egg laying hens is only indirectly relevant, then perhaps this estimate is sufficiently accurate. We will know this until later on after we've developed our capital budgeting model. Let's bring this back to something maybe a little more realistic.
You can document uncertainty during the due diligence process using the influence diagram as a guide to facilitate discussions with relevant subject matter experts. The discussions you facilitate go much differently than, say our traditional approach to preparing a business case. The traditional question is to say, give me your best estimate for this assumption over the forecast period. And when you ask, say a marketing person to forecast demand at selling prices, they're going to spend all kinds of time gathering information about the market and conducting focus groups and completing surveys, which is all wonderful due diligence. But in framing your question in this way, you are holding them accountable for predicting the future, something that is impossible for anyone to do. Instead, let's frame these questions entirely differently.
Let's allow the subject matter expert the freedom to explore the range of possible outcomes. Start by asking them to describe what events what factors what things would influence really extreme outcome, it could be a supply issue. Maybe it's weather related. Maybe terrorism is a big factor, whatever, once you understand the factors that influence and assumption as the subject matter experts to then provide an estimate as to which they have a 90% confidence that the real number will be lower than this number. Now, that's a pretty high level of confidence. But this sets the upper bound, you then do the same thing for the lower bound.
If you were to pick a number or a value that you were 90% certain the real number would be higher than this amount, what would that amount be and that will set your lower bound. And then finally, after all that discussion about the range of possible outcomes, as the subject matter expert to provide you with a immediate outcome or an expected result, a result which there is a 5050 chance Whether the real outcome would be either higher or lower than this amount. This approach is designed to unanchored. The natural tendency for a subject matter expert to fixate on coming up with a base case. Let's look at an example that we should all be familiar with, say oil prices. Over the past 10 years, oil prices have averaged $76.
However, they've been as high as $100, on average in 2008, and as low as $41. In 2004. These prices might illustrate in hindsight, the P 10. p 50. And p 90, establishing the total range of a possible assumption about oil prices. When we conduct our due diligence in this way, there's no concept of developing say a conservative assumption or a conservative case. You don't hedge your base case to protect yourself.
The analysis we will look at later on will help bring risk to the forefront of our capital budgeting decision package. Let's wrap up by reviewing three key points we discussed in this lesson. First, recognize that it's impossible for you or any subject matter expert to predict the future with accuracy, it's more important to embrace it and try to understand the uncertainty and the factors driving it. And influence diagram is one tool you might use to identify and document uncertainty inherent in the strategic drivers that could positively or negatively impact the ultimate return. So the capital investment. Finally, when you embrace uncertainty, it broadens the conversations you now have with your subject matter experts.
No longer do you singularly focused them on giving you one version of a future that everyone knows ultimately will turn out differently. Instead, your due diligence focuses on better understanding and cooperation Following the factors that will feed into the development of an assumption. In our next lesson, we're going to talk about establishing the appropriate discount rate for analysis. Until then,