Question

Risk in capital projects is the probability that a project will earn less than expected. Make up and describe one hypothetical project in each of the replacement, expansions and new venture categories. List a few ways that each might go wrong and cause the cash flow to be less favorable than expected. Can you think of situations in which projects could result in losses? Could the losses exceed the initial investment?

Answer 1

Analyzing different risk in capital projects is key to a company's growth and sucess.

An approach to risk assessment involves classifying the project by type and assigning a risk-adjusted discount rate to each type.

Project can be any of the below types:

Replacement: Requiring replacement of an existing torn/worn equipment with a new one.

For a hypothetical company in a manufacturing industry it would relate to replacing a existing equipment torn/worn in the production process with a new equipment.

In this case the risk-adjusted discounted rate would be K (based on other similar projects in the company)

Less favourable scenario: The above replacement would lead to a less favourable scenario if the replacement equipment does not match or exceed the utilization level of the equipment replaced.

Project loss scenario: Project could go into losses if the equipment does not function as expected leading to lower productivity or requires very high maintainence costs leading to higher expenses resulting in losses  

Expansion: Expansion to existing or related products/ markets. This kind of project is undertaken to expand the business

For a hypothetical company in a manufacturing industry it would relate to setting up a setting up new product line for an existing product or taking the business to new geographies and thus expanding its operations

In this case the risk-adjusted discounted rate would be K + 4% to 6% (somewhat above the current risk level of risk for the company)

Less favourable scenario: The above expansion would lead to a less favourable scenario if the related product launched does not achieve the growth/ sucess it was expected to or the product is not registering enough sales to increase cash flows as expected in case of expansion to new geography.

Project loss scenario: Project could go into losses if the related product launch fails to take off or falls misreably in the market if it does not meet the customer expectations

Expansion projects can go into losses due to political factors, regulatory hurdles leading to delay in setting up factory leading to cost escalations and finally closures

New Venture: In this category the firm is venturing into new lines of business, products and markets.

For a hypothetical company in a manufacturing industry it would relate to setting up a new product line or setting up a new business completely unrelated to the existing business

In this case the risk-adjusted discounted rate would be K + 8% to 12% (clearly above the current risk level of risk for the company)

Less favourable scenario: The above new venture would lead to a less favourable scenario if the new venture launched does not achieve the growth/ sucess it was expected to or the is not registering enough sales to increase cash flows as expected in case of expansion to new continent/country.

Project loss scenario: Project could go into losses if the new venture cost of capital exceeds the rate of return due to failed expectations, cost overruns or due to unforseen events leading to closure of the new venture

In each of the above three categories losses can exceed the initial investment. However, the risk would be lower depending on the project type in descending order. i.e, New Venture (high risk), Expansion (moderate risk) and Replacement (low risk).