Decision-Making Under Uncertainty: How Risk Assessment Impacts ROI Calculations
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Companies often make project and investment decisions based on a simple return on investment (ROI) model with a single hurdle rate. The basic ROI approach is widely used when making purchasing decisions, deciding production strategies, which projects to bid on, and more. When risks are not accurately assessed, the ROI metric can be misleading, leading to the selection of unprofitable projects. A systematic investment in unprofitable projects can, in the short term, drain all of the company’s financial resources and leave it short of liquid assets. A systematic misallocation of resources will result, in the long term, the company to lose its technological and competitive advantage.
Moving away from a simplistic ROI approach is important for all firms, but particularly so for small, growth-oriented, and R&D intensive companies. These companies are often cash-constrained, do not have access to capital markets, and rely crucially on the right project selection to continuously innovate and grow. This class will discuss various sources of risk, ways to measure and quantify these risks, and how to incorporate them the ROI on an on-going basis. Alternatives to the ROI measure will also be discussed. These alternatives become increasingly important when companies have multiple growth opportunities with various degrees of uncertainty.