Risk in capital projects is th
Risk in capital projects is the probability that a project willearn less than expected. Make up and describe one hypotheticalproject in each of the replacement, expansions and new venturecategories. List a few ways that each might go wrong and cause thecash flow to be less favorable than expected. Can you think ofsituations in which projects could result in losses? Could thelosses exceed the initial investment?
Answer:
Analyzing different risk in capital projects is key to acompany’s growth and sucess.
An approach to risk assessment involves classifying the projectby type and assigning a risk-adjusted discount rate to eachtype.
Project can be any of the below types:
Replacement: Requiring replacement of anexisting torn/worn equipment with a new one.
For a hypothetical company in amanufacturing industry it would relate to replacing a existingequipment torn/worn in the production process with a newequipment.
In this case the risk-adjusteddiscounted rate would be K (based on other similar projects in thecompany)
Less favourablescenario: The above replacement would lead to a lessfavourable scenario if the replacement equipment does not match orexceed the utilization level of the equipment replaced.
Project lossscenario: Project could go into losses if the equipmentdoes not function as expected leading to lower productivity orrequires very high maintainence costs leading to higher expensesresulting in losses
Expansion: Expansion to existing or relatedproducts/ markets. This kind of project is undertaken to expand thebusiness
For a hypothetical company in amanufacturing industry it would relate to setting up a setting upnew product line for an existing product or taking the business tonew geographies and thus expanding its operations
In this case the risk-adjusteddiscounted rate would be K + 4% to 6% (somewhat above the currentrisk level of risk for the company)
Less favourablescenario: The above expansion would lead to a lessfavourable scenario if the related product launched does notachieve the growth/ sucess it was expected to or the product is notregistering enough sales to increase cash flows as expected in caseof expansion to new geography.
Project lossscenario: Project could go into losses if the relatedproduct launch fails to take off or falls misreably in the marketif it does not meet the customer expectations
Expansion projects can go into lossesdue to political factors, regulatory hurdles leading to delay insetting up factory leading to cost escalations and finallyclosures
New Venture: In this category the firm isventuring into new lines of business, products and markets.
For a hypothetical company in amanufacturing industry it would relate to setting up a new productline or setting up a new business completely unrelated to theexisting business
In this case the risk-adjusteddiscounted rate would be K + 8% to 12% (clearly above the currentrisk level of risk for the company)
Less favourablescenario: The above new venture would lead to a lessfavourable scenario if the new venture launched does not achievethe growth/ sucess it was expected to or the is not registeringenough sales to increase cash flows as expected in case ofexpansion to new continent/country.
Project lossscenario: Project could go into losses if the new venturecost of capital exceeds the rate of return due to failedexpectations, cost overruns or due to unforseen events leading toclosure of the new venture
In each of the above three categories losses can exceed theinitial investment. However, the risk would be lower depending onthe project type in descending order. i.e, New Venture (high risk),Expansion (moderate risk) and Replacement (low risk).
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