Risk and QuickBooks 2012
Risk is an issue even with simple investments like bank CDs. But with capital investments, no government agency is looking out for your interest and picking up the pieces if things do a Humpty Dumpty and come crashing down.
Capital budgeting and risk management doesn’t really directly relate to using QuickBooks. In some ways, capital budgeting is about a financial management task that is critically important and that you need to think about . . . but a task that QuickBooks doesn’t directly support.
That said, do note that much of the data that you’ve collected with QuickBooks is often extremely useful in getting good estimates of the savings and costs associated with some capital expenditure.
So think for a minute about risk management and assessment in the case of capital expenditures.
Be very careful and thoughtful in coming up with cash flows. The better job that you do thinking about and estimating the cash flows from a capital expenditure, the more reliable and useful your results are. Good cash flow estimates produce good rate of return measurements.
Experiment. You absolutely need to experiment with your assumptions. Make changes and see how those changes impact both the cash flow and rate of return measurements.
Think about the discount rate that you use. It should implicitly take into consideration the risk that an investment makes you face. A finance professor once said, Your discount rate should equal the rate of return that similarly risky investments produce. There is tremendous wisdom in this simple guideline.
In other words, if you’re looking at a very risky investment, that investment should be compared with the hoped-for higher rates of return that other similarly risky investments deliver. You would never pick an investment that, given its risk level, delivers an inferior rate of return.
At the same time, if you’re looking at lower risk investments, you want to use a lower discount rate. A relatively low risk investment in something like an office building, for example, shouldn’t be evaluated with a discount rate that’s maybe appropriate to some super-risky investment in some new bit of leading-edge technology.
Another related point is that maybe you want to try some different discount rates. By experimenting not only with your cash flow numbers but also with your discount rates, you can see how the quality of an investment changes when you use different discount rates (and implicitly make different assumptions about the investment’s risk).
If you do have a building investment under consideration, you should consider all sorts of expenses related to repairing and maintaining the building.
If you’ve been leasing space in someone else’s building, you have to consider all sorts of expenses associated with that, including special insurance that the landlord makes you buy, special amounts that you spend because the space doesn’t quite meet your requirements, and so on. QuickBooks helps you with this type of information.