CHAPTER 12 Capital investment 511- Risk
Investment decisions involve risk. Costs may rise above what was expected, returns may fall short.
A further concern is the extra element of risk associated with an individual investment. Many single
investments carry more risk than groups of investments, especially if those investments have been put
together carefully to manage their risk. Consider for example the Qantas Group, which has a number
of business segments (i.e. Jetstar, Qantas, Qantas Freight and Qantas Frequent Flyer). All of these seg-
ments earn revenues and incur expenses, control assets and have future obligations. The Qantas Group is
managing its risk by offering different products to customers (i.e. passengers) and operating in different
segments of the market (e.g. passenger transport, freight and loyalty programs). However, a business
focusing on one project carries more risk (e.g. a pharmaceutical company developing a new drug). From
an individual investor perspective, a single investment in one company on the share market is likely to
carry more risk than, say, a deposit with a local building society, where an individual’s funds would be
pooled with other monies and spread amongst different investments. Investors who take on more risk
demand higher returns as compensation for assuming that risk. Thus, more risky investments will have a
risk margin added to their opportunity interest rate, to arrive at a final higher discount rate which in turn
lowers the present value.
- Opportunity cost
Opportunity cost was discussed in relation to a manufacturer supplying coconut oil to Coconut
Plantations. Money also has an opportunity cost. If investors can place their funds in alternative invest-
ments (which they can), then directing their funds to a particular investment has an opportunity cost.
The opportunity cost is the cost of forgoing the benefit from that alternative investment. If the alter-
native investment pays 5 per cent per annum, then the opportunity cost in making the given investment
is 5 per cent.
Remember, we noted earlier that the cash flows are assumed to have been received and paid at the end
of each period. This is a simplifying assumption. In reality, most projects have cash flows received and
paid more or less evenly throughout the year. It is possible to incorporate this pattern of cash flows into
an analysis by using specially calculated daily discount tables. However, we will not investigate this in
this chapter. Just be aware that such a refinement is possible.
Advantages and disadvantages of the NPV method
The advantages of the NPV method are that it takes into account:
- all of the expected cash flows
- the timing of expected cash flows (with cash flows received sooner being more beneficial to the
entity)
- cash flows only, so it is not subject to changing accounting rules and standards as profit figures are.
In addition, the decision rule is explicit, in that positive NPVs will increase entity value, if the data
are correct.
The disadvantages of the NPV method are that:
- the method relies on the use of an appropriate discount factor for the circumstances
- the actual return in terms of the percentage of the investment outlay is not revealed
- ranking of projects in terms of highest NPVs may not lead to optimum outcomes when capital is rationed
- in some cases, it conflicts with IRR rankings. (There also can be multiple IRRs.)
The last three disadvantages may need further explanation. (The first two of these are discussed here,
and the final disadvantage is discussed in the section on the IRR.) Suppose a project’s cash returns have
been discounted by 10 per cent and the calculated NPV is $23 450. From these data, we do not know if
the project can be expected to return 11 per cent, 12 per cent, 13 per cent or 20 per cent. To understand
the ranking problem, consider the following data in table 12.3.