Risk Manage Capital Investment Decisions: A Lease vs. Purchase Illustration

Abstract

This paper demonstrates how to build risk into capital investment decisions. We illustrate how to combine distribution theory, technology, and a business professional’s skills and insight into a capital investment analysis. In addition, we show how management can approximate the risk of each cash flow estimate and display the overall capital investment results. This framework is extended by showing how a mutually exclusive decision can be improved, using a lease versus purchase example.[1] An Excel template is readily available from the authors allowing a hands-on application of the framework presented in this paper. In addition, this paper positions the reader to comfortably use more advanced analytics, such as Monte Carlo simulation, a tool that is readily available in commercial software applications.

This paper focuses on the application of net present value. The advantage of using net present value in a capital budgeting decision is that it shows the potential stakeholder wealth creation and wealth destruction. An internal rate of return analysis is intentionally left out of this paper. According to Brealey, Myers and Allen, Principles of Corporate Finance, New York, NY: McGraw-Hill/Irwin 2006, pp. 91-99, internal rate of return should not be used to evaluate mutually exclusive capital investments.