FREE online courses on Capital Budgeting Analysis - Additional
Considerations in Capital Budgeting Analysis - Adjusting for Risk
We previously learned that we can manage uncertainty by
initiating decision analysis and building options into our projects. We now want
to turn our attention to managing risks. It is worth noting that uncertainty and
risk are not the same thing. Uncertainty is where you have no basis for a
decision. Risk is where you do have a basis for a decision, but you have the
possibility of several outcomes. The wider the variation of outcomes, the higher
the risk.
In our previous example (Example 6), we used the cost of
capital for discounting cash flows. Our example involved the replacement of
equipment and carried a low level of risk since the expected outcome was
reasonably certain. Suppose we have a project involving a new product line.
Would we still use our cost of capital to discount these cash flows? The answer
is no since this project could have a much wider variation in outcomes. We can
adjust for higher levels of risk by increasing the discount rate. A higher
discount rate reflects a higher rate of return that we require whenever we have
higher levels of risk.
Another way to adjust for risk is to understand the impact of
risk on outcomes. Sensitivity Analysis and Simulation can be used to measure how
changes to a project affect the outcome. Sensitivity analysis is used to
determine the change in Net Present Value given a change in a specific variable,
such as estimated project revenues. Simulation allows us to simulate the results
of a project for a given distribution of variables. Both sensitivity analysis
and simulation require a definition of all relevant variables associated with
the project. It should be noted that sensitivity analysis is much easier to
implement since sophisticated computer models are usually required for
simulation.
