Risk Analysis in Capital Investments 209Chapter 11
11. Risk Analysis in Capital Investments
OBJECTIVES
What are the risks involved in investments?
What are the techniques of measuring risk?
What are certainty equivalent cash flows and risk adjusted discount rates?
How should risk be incorporated into capital budgeting analysis?
Introduce simulation through Crystal Ball®.So far, we conducted investment analysis under the assumption that cash flows are certain and known. This
is unlikely in real life situations. The value of NPV, which we computed in many of the earlier examples, is
really one of the many values it can take on due to uncertainty in the underlying variables. In this chapter,
I describe methods of assessing risk in investment decisions. We will answer such questions as:
- What are the risks involved in investments?
- What are the techniques of measuring risk?
- What are certainty equivalent cash flows and risk adjusted discount rates?
- How do we apply these techniques in real life situations?
MEASURING RISK
Uncertainty about a situation can often indicate risk, which is the possibility of loss, damage, or any other
undesirable event. Most people desire low risk, which would translate to a high probability of success, pro-
fit, or some form of gain. For example, if sales for next month are above a certain amount (a desirable event),
then orders will reduce the inventory, and there will be a delay in shipping orders (an undesirable event). If
a shipping delay means losing orders, then that possibility presents a risk. Almost any change, good or bad,
poses some risk. Your own analysis will usually reveal numerous potential risk areas: overtime costs, inventory
shortages, future sales, geological survey results, personnel fluctuations, unpredictable demand, changing
labor costs, government approvals, potential mergers, pending legislation.
Once the risks have been identified, a model can help you quantify the risks. Quantifying risk means put-
ting a price on risk, to help you decide whether a risk is worth taking. For example, if there is a 25 percent