Risk and capital budgeting: A case study using flexible manufacturing

Abstract

Scope and Method of Study: This study examines the issues of and risks involved in choosing between capital investment projects which use either traditional or flexible manufacturing techniques. Three unique measures of risk were developed by the author. The first measure was a ratio of positive net present values to negative net present values. The second measure was a ratio of the lowest cash balance which could be experienced to the minimum cash balance the firm desires to maintain. The third measure of risk was the ratio of the maximum yearly cash outflow experienced in a project to the maximum yearly cash outflow the firm can sustain. The net present value ratio was tested by conducted a Monte Carlo simulation. The other ratios were tested using the worst case information. All the test information used was completely hypothetical and did not concern existing companies.

Findings and Conclusions: All three measures of risk performed well. The net present value ratio was believed to be the most useful measure of risk for most projects. It also has the advantage of being an easily understood measure of risk. Its concept could be easily understood by most executives. The other two measures of risk are also useful, but do not have as wide of a range of applicability as does the first measure.