Every business has to make capital investments or projects of one form or another, in the course of its operations. And most of the time, you have to choose one option out of many to invest in, and forego the others. So any manager always has to weigh different projects on a risk/return basis to decide which one to go with and which one to save for another time.
The easiest way to compare two projects is through their expected rates of return. If you had to invest in a poultry that returns 12% a year, or a fish farm that returns 20% a year, my guess is you’d go with the fish farm. However, your comparison isn’t complete until you adjust each of those expected returns to the amount of risk you have to assume to earn them. In fact, one of the tenets of finance is to rank investments based on risk adjusted returns which gives you a much better idea of what to expect. For instance, a project with an expected return of 20% but a close to 60% chance of complete failure/loss is not a better choice than a 12% return project with an only 25% chance of total loss.
So the first risk to consider is downside risk. What is the worst case scenario of each project? If project A will return 40% but the cost is $1m and the chance of total loss is 35%, and the chance of 50% loss is another 40%, while your chance of success is only 15% will you invest in it when your total capital is $1.2m, knowing well that if you fail, you might go bankrupt? I think not. Probably better to choose a project that may have lower absolute returns, but has way less downside risk.
The second risk to look out for is duration risk. The longer your capital is engaged, the higher the chances of something going bad before you make it back. So on a capital project, you should probably want to calculate your payback period as one of the elements of your risk calculation. The payback period is self explanatory; while it doesn’t tell you how profitable a project will be in absolute terms, it tells you how quickly it pays for itself, or how quickly you recover the money you invest in it. It’s similar but not quite the same as a break even analysis. For instance, if you want to buy a bus for $50,000, which will give you an additional profit of $12,000/yr, then your payback period is 4 years and 2 months (a simplified calculation). If you have a similar investment but one that has a payback period of 2 years, then you know which one you probably want to take.
Of course, depending on the project you’re engaged in, there are tons more risks and analyses to consider when you want to gauge the amount and likelihood of your returns.
And even if you’re not operating a business and are simply checking a business for potential investments, you still need to understand how to make these evaluations so that you can tell the potential impact of a company’s capital investments and how likely they are to translate into higher earnings or losses in the future.