RISK
AND OPPORTUNITY
COST OF
CAPITAL
Measuring Risk and Return
All capital budget decision making involves two basic computations,
one involving the rate of return on the project, called the internal rate of return, and the other, the
amount of risk being undertaken, called standard deviation-coefficient of variation analysis. No
corporate long term investment decision is valid unless this risk / return relationship is established
and computed.
The computation of the amount of comparative risk between
two or more projects or for a single project, is based on well established statistical principles related
to historical data directly associated with the project, or by analogous, credible experience of similar
projects.
The concept of standard deviation, the surrogate for risk,
is a universally accepted, scientific idea that all fortuitous events tend to cluster around an average,
called the mean, and that mean represents the underlying average probability of that event, like sales,
for example.
The extent to which past sales might vary from that mean
represents the risk associated with predicting the future sales of that company or product. That variance
of past results can be measured and quantified and thus compared with other potential investments that
could be made. Thus, variability from an average number represents the basis upon which objective risk
is measured.
This variability as expressed by idea of one standard deviation
from the mean of the experience expresses what statisticians say is about 70% of the what the future experience
is likely to be. That is, the future results are likely to be one standard deviation from the mean about
70% of the time Therefore, when one standard deviation is calculated a degree of confidence is
established about the likelihood a number being above a calculated range. One standard deviation gives
about an 85% confidence level, while two standard deviations from the mean is said to give about 97% confidence
of the likelihood of that a future number will be above two standards deviations from the mean. Thus standard
deviation analysis puts a number or risk.
Unfortunately, that standard deviation computation has to
be adjusted when one compares risk with differing means or expected values. In that scenario, the
standard deviation has to be divided by the mean to develop a risk number called coefficient of
variation, which becomes the quantification of the risk of an investment that is to be compared to
another investment, and is widely used in the capital budgeting process to quantify risk.
The whole idea is that the return one receives on an investment
should fairly represent the risk one takes in making it Otherwise the project will be overpriced. This
is so because risk is always calculated into the price in relation to the return realized. This is part
of the efficient market idea recognized by all knowledgeable purveyors and buyers in all markets. It represents
what is called "entrepreneurial thinking" which is that risk taking is desirable as long as there is a
straight line relationship between risk and return. If there is the risk is fairly priced. This of course,
does not preclude bargain hunting for projects whose prices do reflect the true lower risks of there cash
flows.
