Financial Management

29Capital Investment Decisions—Advanced Topics

In Chapter 28, 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!). In recent years, the pace of change, level of uncertainty, and frequency of black swan events have exacerbated business risks.

Sources of Risk and Uncertainty

• Project-specific risk.
• Competitive risk.
• Industry risk.
• Global and international risk.
• Geopolitical risk.
• Financial market risk.
• Estimation bias.

There are two broad techniques for addressing risk and uncertainty in capital investment decisions:

1. Utilization of an appropriate discount rate for the project risk.
2. Analysis, evaluation, and flexing of financial projections.

Utilization of an Appropriate Discount Rate for the Project Risk Many firms use a single discount rate for all ...