Risk Analysis in Capital Budgeting Decisions
Conceptually, a capital budgeting decision is simplicity itself. The analyst determines the upfront cost of a project, as well as the periodic future cash flows resulting from the project. Those cash flows are then used to calculate either the net present value (NPV) of the project - using the firm's weighted-average cost-of-capital (WACC) as a discount rate - or the internal rate of return (IRR) for the project. If the NPV is positive, or if the IRR exceeds the WACC, the firm undertakes the project; otherwise it doesn't.
The difficulty in making proper capital budgeting decisions arises as a consequence of the difficulty in determining the upfront costs, the periodic cash flows, even the proper WACC. All of these quantities must be estimated, and all of the ensuing estimates will contain some degree of uncertainty; the process in inherently risky.
In their book Fundamentals of Financial Management, 8th edition, South-Western, 1998, authors Eugene F. Brigham and Joel F. Houston include a chapter entitled Risk Analysis and the Optimal Capital Budget. With examples from industry, they illustrate the pitfalls of using uncertain single-point estimates for the cash flows associated with a project. One recommendation in the chapter is to model the uncertainty in all of the quantities being estimated and to use Monte Carlo simulation to produce a probability distrubution for the NPV (or the IRR) of the project. Additionally, the analyst can produce sensitivity analyses to determine the most critical uncertainties in the estimation. The additional information that these statistical techniques provide can aid the capital budget decision-makers and can help them avoid costly mistakes.
As part of the CFA® exam review courses that he teaches, Bill covers the area of risk analysis in capital budgeting. His experience in developing mathematical models for Monte Carlo simulation fit naturally into this very important area of corporate decision-making.
Let Risk Mitigation Associates help you in these areas, and more.