- Evaluate a party’s risk aversion when proposing investment opportunities
A friend comes to you with an investment opportunity. He gives you the information on the investment and you have some concerns, since you tend to be conservative. He says you have the chance at a 1000% rate of return over the next 10 years if the business does well, or you could lose it all if the business fails. Would you put your money in a savings account and be assured a 5% rate of return, or would you put the same amount of money on the risky investment with your friend? How you decide shows your level of risk aversion! Time is also a factor in this decision. Are you willing to risk your funds for ten years, or will you need the principal returned prior to that time?
If you have a high level of risk aversion you will put that money into the bank and collect your small return. If you have a low level of aversion to risk, you will go with the friend’s investment and hope for the best!
Just as some of us are more able to accept risk, businesses have a similar situation. We, as humans, don’t like to expose ourselves to unnecessary risks, so when a business is looking at a huge investment, they want to expose themselves to as little risk as possible.
We can look at this with the following example. You have the opportunity to put your money into a savings account at your local bank that will get you a 2% interest rate, every single year, without fail. You know, for sure, beyond any doubt that your $1000 will be worth $1020 after one year, $1040.40 after two years, and $1061.21 after three years.
Now, let’s take that same $1000 and invest it in a volatile new start-up company. The forecast for this company shows a possibility of a 12% rate of return over the next few years, but there is also the risk of losing part of your $1000 investment. So now, you look at the possibility of having $1404.93 after three years, maybe . . . or the for sure of the interest rate from your bank!
The decision you make, tells us how adverse to risk you may be! Other reasons why someone may be adverse to risk include the desire to retire after three years. In this case, they may be less willing to risk the for sure scenario for the maybe. In the business world, if a new product line is untested, a company may be less likely to invest $100,000 in a new piece of equipment that has the possibility of a large rate of return, if they have the option to invest the same $100,000 in a tested market with a lower rate of return, but one that is less risky.
How long will an investment take to pay back the initial cash outlay? This factor is important as we discuss risk. The longer it will take to get the initial investment back, the more risk a company may face. There may have been errors in calculating the project initially. Over time, the market may change, creating additional risk for a capital purchase. This is one factor in determining the time horizon for a capital project.
The time horizon will vary based on industry as well. An example may be a pharmaceutical company, which will be looking at a potential investment in a new drug based on the life expectancy of the patient receiving the drug. This could be an extended time period. A software company, may be looking at a short time horizon, as new software comes out quickly and is replaced quickly.
Machinery in a printing company may have a 15 year time horizon, as this equipment does not become obsolete as quickly as a laptop computer does. The company investing in new equipment or facilities to build computer components may only be looking at a one to three year time horizon, thus will need to adjust their risk and rate of return on the investment to the anticipated life of the investment.
There are many complex formulas and calculations necessary when looking at the inherent risks of an investment, particularly a large capital investment. Variation of a percent one direction or the other could expose a company to either a huge loss, or a huge gain! These calculations and decisions cannot be made lightly, and take great skill.
- How many years will it take to get back our initial investment?
- What is the life of the equipment, building or project?
- What will the market be like for this product in five, ten or twenty years?
- Who might jump in as competition after we complete this capital project?
- Will the equipment become obsolete before we can get back our investment?
The questions surrounding capital budgeting and investment choices are staggering. Managers need to evaluate each of these decisions based on a variety of factors, and there is still a great deal of room for error. When calculating net present value, this calculation assumes that we will be investing right now, or not at all. This may not be the only option. It might be possible to do this capital expenditure today or in three years. What are the differences if we make a different decision?
Salvage value or resale of the equipment may be another option that influences an investment decision. We may be able to use it for five years, and sell it to another company to recover some of our investment. But HOW do we know if that is the case? We can’t. So we need to make some assumptions and do the best we can in determining if an investment or capital expenditure will be profitable for the company.