Corporate Finance, 5th Edition

Chapter 30 Risk and investment analysis

When uncertainty creates value . . .

Valuing an investment by discounting future free cash flows at the weighted average cost of capital can provide some useful parameters for making investment decisions, but it does not adequately reflect the investors’ exposure to risk. On its own, this technique does not take into account the many factors of uncertainty arising from industrial investments. Attempting to predict the future is too complicated (if not impossible!) to be done using mathematical criteria alone.

Accordingly, investors have developed a number of risk analysis techniques whose common objective is to know more about a project than just the information provided by the NPV. Nonetheless, these traditional approaches to risk analysis suffer from an important shortcoming: they don’t consider the value of flexibility. Recently, options theory vis-à-vis investment decisions has begun to allow investors to assess some new concepts that are crucial to investment analysis.

Section 30.1 Assessing risk through the business plan

1. Building a business plan

The reader must realise that the business plan is the first stage in assessing the risks related to an investment. The purpose of the business plan is to model the firm’s most probable future, and it helps to identify the parameters that could significantly impact on a project’s value. For example, in certain industries where sales prices are not very important, the model will be ...