Online Financial Courses - Capital Budgeting AnalysisProvided by : Matt H. Evans
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Course 2: Capital Budgeting Analysis
Chapter 4: Additional Considerations in Capital Budgeting AnalysisWhenever we analyze a capital project, we must consider unique factors. A discussion of all of these factors is beyond the scope of this course. However, three common factors to consider are:
- Compensating for different levels of risks between projects.
- Recognizing risks that are specific to foreign projects.
- Making adjustments to capital budgeting analysis by looking at the actual results.
Adjusting for RiskWe 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.
International ProjectsCapital investments in other countries can involve additional risks. Whenever we invest in a foreign project, we want to focus on the values that are added (or subtracted) to the Parent Company. This makes us consider all relevant risks of the project, such as exchange rate risk, political risk, hyper-inflation, etc. For example, the discounted cash flows of the project are the discounted cash flows of the project to the foreign subsidiary converted to the currency of the home country of the Parent Company at the current exchange rate. This forces us to take into account exchange rate risks and its impact to the Parent Company.
Post AnalysisOne of the most important steps in capital budgeting analysis is to follow-up and compare your estimates to actual results. This post analysis or review can help identify bias and errors within the overall process. A formal tracking system of capital projects also keeps everyone honest. For example, if you were to announce to everyone that actual results will be tracked during the life of the project, you may find that people who submit estimates will be more careful. The purpose of post analysis and tracking is to collect information that will lead to improvements within the capital budgeting process.
Course SummaryThe long-term investments we make today determines the value we will have tomorrow. Therefore, capital budgeting analysis is critical to creating value within financial management. And the only certainty within capital budgeting is uncertainty. Therefore, one of the biggest challenges in capital budgeting is to manage uncertainty. We deal with uncertainty through a three-stage process:
1. Build knowledge through decision analysis.
2. Recognize and encourage options within projects.
3. Invest based on economic criteria that have realistic economic assumptions.
Once we have completed the three-stage process (as outlined above), we evaluate capital projects using a mix of economic criteria that adheres to the principles of financial management. Three good economic criteria are Net Present Value, Modified Internal Rate of Return, and Discounted Payback.
Additionally, we need to manage project risk differently than we would manage uncertainty. We have several tools to help us manage risks, such as increasing the discount rate. Finally, we want to implement post analysis and tracking of projects after we have made the investment. This helps eliminate bias and errors in the capital budgeting process.
Chapter 4 pointsAdjusting for Risk