Thinking about Risk with Capital Investments
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.
So think for a minute about risk management and assessment in the case of capital expenditures. Here are three important considerations:
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. It would be very interesting to see what effect a lower inflation, or appreciation, rate has on the ultimate rate of return. A 2% inflation rate would dramatically change the cash flows and the rate-of-return measurement for this investment. Similarly, an inflation rate of 5% or 6% over 20 years would also dramatically change things.
Think about the discount rate that you use. The discount rate should implicitly take into consideration the risk that an investment makes you face. Your discount rate should equal the rate of return that similarly risky investments produce. 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).