Page 82 - DMGT302_FUNDAMENTALS_OF_PROJECT_MANAGEMENT

Unit 4: Project Budgeting

Mathematical formulas that predict a single rate of return or “best estimate” are not enough. The Notes
author’s approach emphasizes the nature and processing of the data used and specific combinations
of variables like cash flow, return on investment, and risk to estimate the odds for each potential
outcome. Managers can examine the added information provided in this way to rate more
accurately the chances of substantial gain in their ventures. The article, originally presented in
1964, continues to interest HBR readers. In a retrospective commentary, the author discusses the
now routine use of risk analysis in business and government, emphasizing that the method
can—and should—be used in any decision-requiring situations in our uncertain world.
Of all the decisions that business executives must make, none is more challenging—and none
has received more attention—than choosing among alternative capital investment opportunities.
What makes this kind of decision so demanding, of course, is not the problem of projecting
return on investment under any given set of assumptions. The difficulty is in the assumptions
and in their impact. Each assumption involves its own degree—often a high degree—of
uncertainty; and, taken together, these combined uncertainties can multiply into a total
uncertainty of critical proportions. This is where the element of risk enters, and it is in the
evaluation of risk that the executive has been able to get little help from currently available
tools and techniques.

There is a way to help the executive sharpen key capital investment decisions by providing him
or her with a realistic measurement of the risks involved. Armed with this gauge, which evaluates
the risk at each possible level of return, he or she is then in a position to measure more
knowledgeably alternative courses of action against corporate objectives.

Need for New Concept

The evaluation of a capital investment project starts with the principle that the productivity of
capital is measured by the rate of return we expect to receive over some future period. A dollar
received next year is worth less to us than a dollar in hand today. Expenditures three years hence
are less costly than expenditures of equal magnitude two years from now. For this reason we
cannot calculate the rate of return realistically unless we take into account (a) when the sums
involved in an investment are spent and (b) when the returns are received.
Comparing alternative investments is thus complicated by the fact that they usually differ not
only in size but also in the length of time over which expenditures will have to be made and
benefits returned.
These facts of investment life long ago made apparent the shortcomings of approaches that
simply averaged expenditures and benefits, or lumped them, as in the number-of-years-to-pay-
out method. These shortcomings stimulated students of decision making to explore more precise
methods for determining whether one investment would leave a company better off in the long
run than would another course of action.
It is not surprising, then, that much effort has been applied to the development of ways to
improve our ability to discriminate among investment alternatives. The focus of all of these
investigations has been to sharpen the definition of the value of capital investments to the
company. The controversy and furor that once came out in the business press over the most
appropriate way of calculating these values have largely been resolved in favor of the discounted
cash flow method as a reasonable means of measuring the rate of return that can be expected in
the future from an investment made today.
Thus we have methods which are more or less elaborate mathematical formulas for comparing
the outcomes of various investments and the combinations of the variables that will affect the
investments. As these techniques have progressed, the mathematics involved has become more
and more precise, so that we can now calculate discounted returns to a fraction of a percent.

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