In Chapter 20, we introduced key elements of capital investment decisions. In this chapter, we will cover advanced topics, including dealing with risk and uncertainty, capital budgeting and rationing, and methods of evaluating the effectiveness of the capital investment decision process. Finally, we will review best practices in presenting capital investment decisions.
DEALING WITH RISK AND UNCERTAINTY IN CAPITAL INVESTMENT DECISIONS
Since we are dealing with expectations, predictions, and projections of future performance, capital investment decisions have an inherent level of risk and uncertainty. The risk and uncertainty can be extreme in projects that extend over a long period or involve rapidly changing environmental and competitive factors (almost all markets now!).
There are two broad techniques for addressing risk and uncertainty in capital investment decisions:
- Use of an appropriate discount rate for the project risk.
- Analysis, evaluation, and flexing of financial projections.
Utilize an Appropriate Discount Rate
Many firms use a single discount rate for all capital projects. In many cases, the origin and basis of the discount rate is not known or well understood. The discount rate should be reviewed periodically, and ...