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Corporate Finance Theory and Practice, Third Edition by Antonio Salvi, Yann Le Fur, Maurizio Dallocchio, Pascal Quiry

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Chapter 31

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. In fact, these techniques allow the investor to:

  1. know the most important sources of uncertainty of a project and the quantitative impact of each of them. With this information, a manager can decide if it is necessary to conduct additional analysis, such as market research, product testing, logistics alternatives, and so on; and
  2. identify a project's key value drivers so that the manager can accurately monitor these factors before, during and after an investment is made.

Nonetheless, these traditional approaches to risk analysis suffer from an important shortcoming: they don't consider the value of flexibility. Recently, options theory of investment decisions has begun to allow investors to assess some new concepts that are crucial to investment analysis.

Section 31.1 ...

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