Risk and Non-Financial Criteria

A warning! Note the caveat in the chapter introduction: “The difficult part is choosing where to invest— that is, determining those projects with the highest rewards and the least risk” (italics added). As a practical matter, many criteria that should be included are difficult to translate into a net present value, modified internal rate of return, or years to break even. They involve uncertain information and risks. They include not knowing exactly what the future will bring, how competitors will act, the technical

392 ❧ Corporate Financial Analysis with Microsoft Excel ® Figure฀12-21

Solution with Maximum Present Value and Maximum Sum of Uncommitted Funds

1 Example 12-10: GOLIATH INDUSTRIES (Increase in available funds + 2nd goal)

2 Input Data

Annual Costs 3 Option

Present

Year 2 Year 3 4 Modernize existing plant

300,000 6 Expand distribution network

5 Build new plant

20,000 7 Redesign existing product A

8 Redesign existing product B

45,000 9 Develop new product X

200,000 $ 75,000 10 Develop new product Y

250,000 $ 200,000 11 Available funds

Choices 13 (1 = Yes,

Annual Costs 14 Option

Present

Year 2 Year 3 15 Modernize existing plant

- $ - 16 Build new plant

300,000 $ - 17 Expand distribution network

0 $ - 18 Redesign existing product A

- $ - 19 Redesign existing product B

45,000 $ - 20 Develop new product X

- $ - 21 Develop new product Y

22 Present value and annual costs

23 Uncommitted funds

5,000 $ 100,000 24 Build OR modernize plant constraint

First goal

1 Second goal

25 Sum of uncommitted funds

Key cell entries:

B24

=B15+B16

C15

=$B15*C4, copy to C15:F21

C22

=SUM(C15:C21), copy to D22:F22

D23

=D11–D22, copy to E23:F23

Solver settings: Target cell is B25, to be maximized.

Cells to vary are B15:B21 Constraints: B15:B21=binary

Achieving the first goal is a constraint

D22:F22<=D11:F11

on achieving the second goal.

B24=1 (Either modernize or build new plant.)

C22=1650000

Options: Assume linear model

feasibility of new products or production methods, energy costs, environmental hazards and constraints, political stability of foreign countries in which facilities might be located, the volatility of currency exchange rates, the length of time for completing construction of new facilities or remodeling existing ones, and so forth. Such criteria are difficult to quantify fully. Each will have different levels of importance. How well an investment satisfies them may be a subjective judgment rather than a hard number.

When decisions involve criteria that are subjective, “Rating and Ranking” scorecards can be used to help make the decisions more objective. Figure 12-22 illustrates the method.

Capital Budgeting: The Basics ❧ 393 Figure฀12-22

Scorecard with Ratings for a Particular Investment or Project

1 “RATING AND RANKING” SCORECARD FOR AN INVESTMENT OR PROJECT

2 Relative

Rating of Potential Investment

Terrible Weighted 4 Criterion

3 Importance Excellent

75 50 25 0 Score 5 Net present value

or Weight

1 30.00 6 Technical feasibility

1 15.00 7 Political feasibility

1 5.00 8 Market competition

1 0.00 9 Time to complete

Total weighted score

Key Cell Entry: H5: =B5*SUMPRODUCT($C$4:$G$4,C5:G5), copy to H6:H9

Figure 12-22 lists five criteria (Column A) and their relative importance (Column B). The degree to which a project satisfies the criteria is judged excellent, good, fair, poor, or terrible—with a numerical value attached (Columns C to G). In Figure 12-22, the ratings for a particular project against each of the criteria are indicated by entering the number 1 in the appropriate cells. For example, the investment in Figure 12-22 is rated good for its net present value, excellent for its technical feasibility, and so on to a rating of fair for the time to complete. Multiplying a criterion’s relative importance by a project’s rating for the criterion gives the weighted score for the criterion (Column H). Thus, the weighted criterion score for satisfying the net present value criterion is 30.00 (calculated as 40 percent of 75). Adding the weighted scores for all criteria gives the investment’s total weighted score, which is 55.00 (Cell H10).

Each investment is rated in the same manner, and the investments are ranked in the order of their total weighted scores. The scorecard technique can be used to solicit the ratings of several judges and minimize personal biases. Each judge uses the scorecard approach to rate each investment in a consistent manner. The priorities for the different investments are then ranked according to the judges’ average total weighted score for each project. Projects with higher values for their average total weighted scores are given higher priority than those with lower values. The scorecard helps ensure completeness and consistency among the judges in ranking alternative.

The choice of the scale for project rating is arbitrary and not important. Instead of a scale from 0 to 100, as in Figure 12-22, a scale from 0 to 10 might be used. The important thing is that the scale be applied consistently among judges and among the competing investments.

Admittedly, ranking isn’t completely objective. The list of desirable criteria, their relative importance (or “weight”), and the ratings of how well an investment satisfies the criteria depends on the knowledge and experience of those judging the alternatives. The chief values of this approach are that it evaluates projects in a consistent manner and it helps avoid overlooking things that should be considered.

394 ❧ Corporate Financial Analysis with Microsoft Excel ®

The technique is certainly not new. Most executives and lower-level managers already use it, although often subconsciously and superficially. Its value is enhanced by formalizing it into a well-defined procedure. This helps accomplish the following:

1. It motivates decision-makers. A formal procedure forces them to clarify their thinking and evaluations, and to develop clear concepts of worth and value relevant to the project and its cost.

2. It improves objectivity. A formal procedure helps limit prejudices and personal biases that might otherwise influence decisions.

3. It provides a systematic and consistent basis for evaluating projects. This is especially important when evaluations are sought from a number of judges who represent different points of view or biases.

Figure 12-23 summarizes the steps in assessing alternatives by ranking. Note that developing the procedure and using it to evaluate specific alternatives are separate steps. After the procedure has been devel- oped, judges use it to rate each investment or project and use their total weighted scores to rank them.

Risk and Non-Financial Criteria