Introduction to Corporate Finance

11: Risk and Capital Budgeting

benefit analysis should be economic impacts
and not simply financial transfers between
parties, or second round effects; all impacts
should be incremental; and should all be
directly associated with the initiative.
3 Consider non-monetised benefits and
costs. Where impacts cannot be robustly
expressed in monetary units (‘non-
monetised’), Infrastructure Australia will
nevertheless incorporate them into the
appraisal process and requests proponents
to provide supporting information on the
scale of these impacts.
4 Consider both the overall efficiency
of an initiative (the combined scale of
benefits and costs), as well as its equity
and distributional impacts. Efficiency is
determined by comparing the benefits
and costs of an initiative – it specifically
addresses the question: ‘When all the
benefits and costs are combined, will the
initiative deliver net benefits (ie benefits in
excess of costs)?’ Equity and distributional
impacts relate to who bears the benefits
and costs. Thus, to aid its decision making,
Infrastructure Australia not only requires
the benefit cost ratio as a measure of net
benefit, but also a breakdown of who
is likely to bear the benefits and costs,
and when.

5 Consider issues of risk and uncertainty.

Infrastructure Australia is fully aware that the

future cannot be predicted with certainty,

and that economic growth, individuals’

behaviour, oil prices, carbon prices and

so on may vary over time. To ensure that

the appraisal process is robust to potential

changes, Infrastructure Australia requests

a series of sensitivity tests of the demand

modelling and cost benefit analysis results.

Infrastructure Australia requires all proponents

to submit detailed appraisal information in

support of all initiatives. This should provide

complete transparency of data, assumptions,

and methodologies used; comprehensive

supporting evidence to justify assumptions,

including independent verification of demand

forecasts and costings where possible; and a

detailed picture of the results of the appraisal.

Australian Government Infrastructure Australia, Better Infrastructure

Decision-Making, pp. 24–5.

As we shall see, this range of issues to consider can

apply for any project. It is encouraging to see the

textbook recommendations for capital budgeting

being used in actual market decision-making.

Source: Australian Government Infrastructure Australia, Better

Infrastructure Decision-Making: Guidelines for making submissions to

Infrastructure Australia’s infrastructure planning process, August 2014.

http://www.infrastructureaustralia.gov.au/ priority_list/files/Reform_and_

Investment_Framework_Guidance_August_2014.pdf.

Accessed 2 May 2015. Used under Creative Commons Attribution 3.0

Australia licence (CC BY 3.0).

LEARNING OBJECTIVES

After studying this chapter, you should be able to:

understand operating leverage and

financial leverage, and the potential effect

each of them has on a company’s cost of

capital

estimate the company’s weighted average

cost of capital, both with and without

the allowed tax deductibility of interest

payments to bondholders

review the roles of breakeven analysis and

sensitivity analysis in evaluating investment

opportunities

explain how scenario analysis and

decision trees can be used to assess an

investment’s risk

describe the types of real options

and their role in valuing potential

investments

discuss the strategic aspects of capital

budgeting with regard to competition and

the role of real options in improving the

quality of decisions.

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