Profitability Ratios

Whenever we analyze a capital project, we must consider unique factors. A discussion of all of these factors is beyond 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 atactual results.

Adjusting for Risk

We 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 notsame 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. wider the variation of outcomes, higher the risk.

In our previous example (Example 6), we used the cost of capital for discounting cash flows. Our example involvedreplacement 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? answer is no since this project could have a much wider variation in outcomes. We can adjust for higher levels of risk by increasingdiscount 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 understandimpact 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 determinechange 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 withproject. It should be noted that sensitivity analysis is much easier to implement since sophisticated computer models are usually required for simulation.

International Projects

Capital investments in other countries can involve additional risks. Whenever we invest in a foreign project, we want to focus onvalues that are added (or subtracted) to the Parent Company. This makes us consider all relevant risks ofproject, 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 toforeign subsidiary converted to the currency of the home country of the Parent Company atcurrent exchange rate. This forces us to take into account exchange rate risks and its impact toParent Company.

Post Analysis

One of 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 withinoverall 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 life of the project, you may find that people who submit estimates will be more careful. purpose of post analysis and tracking is to collect information that will lead to improvements withincapital budgeting process.

Course Summary

long-term investments we make today determinesvalue we will have tomorrow. Therefore, capital budgeting analysis is critical to creating value within financial management. Andonly certainty within capital budgeting is uncertainty. Therefore, one of 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 completedthree-stage process (as outlined above), we evaluate capital projects using a mix of economic criteria that adheres toprinciples 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 increasingdiscount rate. Finally, we want to implement post analysis and tracking of projects after we have madeinvestment. This helps eliminate bias and errors incapital budgeting process.