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.


Copyright © 1998 South-Western College Publishing. All Rights Reserved.
webmaster