Capital Investment Risks Analysis

If you were given a choice between two projects with the same return, you almost certainly would choose the project with less risk. The higher-risk project could be justified only by a higher return. This is why you must make some provision for assessing the risk in a proposed capital project. Without knowing the risk, you are not in a position to judge whether the project is suitable. At the outset, you should recognize that risk analysis is a difficult job. No method of risk analysis is entirely satisfactory, and each requires a good deal of expertise and judgment on the part of management. Moreover, many risks are difficult to reduce to numbers. For this reason, you should regard the risk analysis methods discussed below as tools. They are not substitutes for sound business judgment. They do, however, force you to view the various projects in the same light, which highlights risk and permits you to compare all of them.


In this type of analysis, you attempt to isolate those factors that would have the most impact on cash flow if they were altered. You can identify any number of key variables, such as a sales downturn, the time it takes to put the project into place, increased costs, an economic slowdown and marketing difficulties. After each key variable has been identified, it is changed slightly and NPV is recalculated on the basis of the different cash-flow assumptions. Then the effect of the change is noted and ranked.
Illustration: The ABC Company is considering the introduction of a new product that has a net present value of $40,000 over five years. It determines that the most critical variables in its NPV calculations are anticipated sales, pre-production costs and distribution costs. The company then assumes a 10 percent change in each of these variables and recalculates NPV in all three cases. Assuming the following NPV figures, its weighted-risk analysis might look something like this:

Change in Variable Change in NPV
Sales –10% –30%
Distribution costs +10% –25%
Pre-production costs +10% –15%

In this case, a sales slowdown produces the greatest risk and trims the company’s NPV by 30 percent, or $12,000 on a 10 percent sales dip. Also, it had better keep a watchful eye on distribution costs if the company does go ahead with the project. A 10 percent rise there will cut the NPV by $10,000. Pre-production costs are important but exert less impact than the first two variables.

➤ Observation: Weighted-risk analysis can be very informative, particularly if you are astute enough to isolate the key variables. However, this method also has some limitations. First, there is no provision for measuring the probability of changes in the key factors. Also, changes in a combination of less influential factors could result in a substantial change in cash flows.

Adjusting for Probabilities
Turn back once again to the ABC Company’s illustration (pages 62–64). We have already demon¬strated that the project would be profitable at both 9 percent and 10 percent discount rates, but would produce only a marginal profit at 11 percent. Your company’s finance department has likely developed estimates of the probability for each cost of capital, based on the outlook for your industry and economic projections. Obtain these estimates from the department.
A company estimates the probability of each discount rate for each year that the project will be in force. Then, NPV for each year is adjusted for the probability. Example: Refer to the table

below. In Year 1, ABC estimates only a 10 percent chance of a 9 percent discount rate. Therefore, the 9 percent NPV of $13,755 becomes $1,375 ($13,755 x .10). Similarly, the 80 percent probability of a 10 percent discount rate translates into $13,635 x .80, or $10,908. Add to that the $1,351 from the 11 percent column ($13,515 x .10), and the adjusted NPV for Year 1 becomes $13,634. After adjusting for all five years, NPV is a positive $1,759 for the project—an indication that the ABC Company should proceed.


Year Discount Rate of 9% Discount Rate of 10% Discount Rate of 11% Adjusted Present Value
1 10% 80% 10% $13,634
2 20 70 10 12,417
3 30 60 10 11,329
4 20 60 20 11,955
5 20 60 20 12,424
Total Cash Flow $61,759
Capital Cost 60,000
Adjusted NPV $ 1,759


The attempt to measure the probability of different scenarios adds a new dimension to risk analysis and can be quite helpful. But remember that it is difficult to assign probability levels four or five years into the future.

Alternate Scenarios Measure Risk
With this method, you develop three separate NPV or IRR studies for each project. You assume that (1) everything will go exactly as planned, (2) nothing will go right, and (3) things will go more or less as expected, with some bugs. Then you compare the varying degree of risk in each project. For instance, you find two projects with the same midpoint NPV, but one with much more risk if nothing goes right. In that case, you would probably choose the project with the lower risk. It is relatively easy to compare different projects with this method. However, it is also unre¬alistic in that there are few projects launched where everything goes right, and just as few where everything goes wrong. Moreover, there is no adjustment for the various probabilities.