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Incorporating Risk Into

Capital Budgeting Decisions


RIF 004

Speakers:
Kevin Moss, Michelin
Dan McGarvey, Marsh
Learning Objectives
At the end of this session, you will:
•  Understand the capital budgeting process and various methods
for allocating capital to competing projects

•  Be able to articulate several options for incorporating the risk


associated with each project into the evaluation process

•  Understand the value of risk evaluation and tough questions in


selecting the best from among several competing options that
all present a degree of risk

•  Be armed with suggestions for alternatives to reduce the risk


associated with an individual capital budgeting proposal
CFO For a Day
CFO For a Day

Rule #1: You Can’t Make


Everybody Happy
Free Cash Flow –
A Precious Commodity
 Opera'ng  Revenues  
-­‐  Opera'ng  Expenses      From  Net  Income  we  
=  EBITDA   subtract  dividends  to  
-­‐  Deprec./Amor'za'on  
be  paid  to  
shareholders  along  
=  EBIT  
with  any  mandatory  
-­‐  Taxes   expenses  –  leaving  us  
-­‐  Interest  Expense   a  small  amount  to  
=  Net  Income   invest  in  the  firm.  
Options for Free Cash Flow
•  Hold for Later Use
•  Invest in Business
•  Buy Back Stock
•  Increase Dividend
•  Declare Special Dividend

Investors  watch  the  capital  


Budge5ng  process  with  interest,  
in  that  any  funds  reinvested  in  
the  business  –  at  least  in  theory  
–  came  out  of  their  pockets.  
Capital Budgeting –
It Is a Hard Science…

And Risk
Management
is at the
heart of it!
Capital Budgeting
•  Free cash flow is a scarce resource – there will never be
enough to fund all proposals received

•  Traditional capital budgeting orders the proposals according to


the greatest potential return (highest Net Present Value (NPV)
or Internal Rate of Return (IRR))

•  Project cash requirements and estimated cash inflows are


estimated for a foreseeable timeframe (5 – 10 years)

•  A discount rate is applied to reduce all cash inflows and


outlays into present value dollars. Another option reduces
these flows to an effective Internal Rate of Return (IRR)

•  All other things being equal, the highest NPV (or IRR) is the
first to be funded, followed by the next, until investment funds
are exhausted
The “Hurdle Rate”
•  We know the risk tolerance and reward expectations for the
shareholders of any company
•  The golden rule of resource allocation: If the return presented
is lower than the minimum expected by shareholders, GIVE
THE MONEY TO THEM INSTEAD AS DIVIDENDS
•  The Hurdle Rate is this minimum threshold for capital
investments needed to meet shareholder expectations
•  Of course, many capital expenditures do not yield profitable
returns, but may be required by regulators or otherwise
considered mandatory
•  In any case, the first evaluation factor for any investment is
whether it is in line with stated corporate objectives and the
established risk philosophy of the firm
The First Cut
Does this proposal make
good sense for us?
•  Is it consistent with the company’s stated
objectives?
•  Is it in line with the expectations of our
stakeholders?
•  Do we have the skills and experience to make
this work?
•  Is there any risk to our brand?
Sample Options: $5 Million
Develop and launch a three-year marketing campaign
to increase familiarity of our signature product with a
younger audience:
•  New packaging
•  Product placement in key
movies/TV shows
•  One Super Bowl ad
•  Social networking
•  Internet ad campaign
•  “Our product is hip!”
Sample Options: $5 Million
Enter a new geography that our market researchers
believe has the potential to create expanded demand
for our product:

•  Partnership with local


distributor
•  Advertising campaign
•  Modified packaging
•  Local celebrity endorsement
•  Free product sample
campaign
•  Lease production facility
Sample Options: $5 Million
Partner with a startup chain of food court / airport
sandwich stands specializing in Philadelphia
cheese steaks:

•  Exclusive customer
•  Advertising tie-in
•  Broaden appeal for
product
•  Drive demand for product
•  Potentially profitable
investment
Sample Options: $5 Million
Develop new flavors of existing product to draw in new
customers based upon market research surveys as to
what would make customers consider our brand:

Initial Concepts:
•  Smoked flavor
•  Bacon flavor
•  Hot chili flavor
CFO Challenge:
“Make Good Choices”
How Would You Characterize the Risk
Associated With These Four Options?
•  Youth oriented advertising campaign?
•  Expand to foreign market with partnership
investment?
•  Investing in startup restaurant chain?
•  Launch two new product flavors?
Net Present Value (NPV)
•  Calculates the net worth
in dollars of investments
and returns spread over a
number of years
•  Requires a company to
determine its “Discount
Rate” – typically a
minimum acceptable rate
of return for the
organization
Basis for Net Present Value
•  A dollar in hand is worth more than the same
dollar promised in a future period
•  There is an “Opportunity Cost” associated with a
dollar committed today to any project
•  A project launched today must return a greater
rate than our capital cost to fund it

TIME REALLY IS MONEY!


YOU MUST BELIEVE THIS!
NPV – Advertising Campaign
Year 2016 2017 2018 2019 2020

Cost (2,500) (1250) (1250) 0 0

Revenue 500 2700 2550 1100 900

Net (2,000) 1450 1300 1100 900

NPV1 (2000) 1343 1115 873 662

1 Discount rate 8%

Net Present Value


(Advertising) = $1,993,300
Risk Adjusted Discount Rates
•  Assign categories of risk – perhaps 1 (results fairly
assured) to 4 (high degree of volatility)
•  Amend discount rate appropriately – if normal rate is
8, a project rated “3” might be evaluated with a
discount rate of 10
•  This essentially allows options to be compared on
an “apples to apples” risk basis
•  It essentially raises the “hurdle rate” for projects
offering greater risk
•  Requires the skills of a risk professional to ask hard
questions and assign appropriate risk scores
NPV – International Launch
Year 2016 2017 2018 2019 2020

Cost (2,000) (450) (700) (850) (950)

Revenue 550 1200 1,800 2,000 2,200

Net (1,450) 750 1,100 1,150 1,250

NPV1 (1,450) 695 943 914 918

 1Discount rate 8%

Net Present Value


= $2,020,000
NPV – International Launch
Year 2016 2017 2018 2019 2020

Cost (2,000) (450) (700) (850) (950)

Revenue 550 1200 1,800 2,000 2,200

Net (1,450) 750 1,100 1,150 1,250

NPV1 (1,450) 681 908 863 854

1Discount rate 10%

Risk Adjusted Net Present Value


= $1,856,000
Time as a Risk Factor
•  All other things being equal,
a project that breaks into
profitability in the shorter
time period presents lower
risk

•  It is not uncommon,
therefore, to prescribe a
minimum “Breakeven
Period” to weed out projects
that require long periods of
time to mature

•  Why does a longer time


period increase risk?
The Value of the “Real Option”
•  A risky project that offers the opportunity for some
optionality in implementation or the option to exit without
undue brand damage is more attractive than one with
limited flexibility

•  It is useful to ask the optionality question when


evaluating a project perceived to present a greater than
average degree of risk

•  For two projects with an equal opportunity for success


(but both perceived to be risky) – the best option might
be the one whose exit cost NPV is lower in the event of
abject failure
Risk Adjusted Internal Rate of Return
•  Assign categories of risk – perhaps 1 (results fairly
assured) to 4 (high degree of volatility)
•  Amend required IRR – if normal required IRR is 10%,
a project rated “4” might be evaluated with a
minimum required IRR of 18%
•  Once again, this exercise essentially raises the
“hurdle rate” for projects offering greater risk
•  An accurate and objective risk scoring exercise
remains key, and requires the efforts of a seasoned
and knowledgeable risk professionals
Using Risk Adjusted Cash Flows
•  Through the use of modeling and simulation (fault trees, etc.), it
is possible to determine a range of cash flows for each period

•  The range of possible outcomes (standard deviation) is likely


tied to the measure of risk or volatility

•  NPV analysis could therefore be applied against the most


probable value for each period
Questions for the Risky Project
•  Is the project in line with stated corporate objectives and
not in violation of any risk parameters?

•  Does the implementation team have experience in this


area of endeavor?

•  Has a risk management plan been formulated to address


key potential concerns?

•  If specialty insurance or risk services are part of this


project, is the cost reflected in the business plan?

•  Are there “off-ramps” available? Can the project be


phased in over time to allow periodic evaluation?
Adding a Dollar Cost of Risk
Very often a proposed business plan fails to
incorporate an appropriate cost of risk
•  Potential questions to address:
–  Have you built in the cost of specialty insurances required?
–  Does your manning plan incorporate an appropriate number
of loss control and/or quality assurance personnel?
–  Do you have all the permits required to support this
venture? Are there hidden frictional/transactional costs?
–  What is the financial condition of our prospective partner?
Accoun'ng  for  Poten'al  Delay
•  Is insurance, liquidated damages, or other vehicle available to
help partially offset the cost of project delay?

•  What has been the experience of similar projects in the last


three years? Why do we believe our experience would be any
more favorable?

•  Sensitivity analysis – what impact on profitability would a delay


equal to the longest peer delay have on the project?
The Outcome
•  The cost of Political Risk insurance and a 2% higher discount
rate rendered the overseas expansion opportunity unattractive
as respects profitability. Questions also arose concerning the
track record of the proposed partner
•  A venture capital fund specializing in hospitality enterprises
was identified to partner with the restaurant chain. An
agreement was struck to serve as sole supplier and for an
advertising tie-in
•  The advertising campaign was launched with an added feature
of an “off ramp” at the two year point. The campaign will be
halted in the event it does not produce 75% of projected sales
•  Two new flavors were moved to additional market research
testing, with an option to launch if favorable results obtained
Ques'ons?  
Thank You For Your
Kind Attention

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