Logical & Correct Reasoning: Risk Tolerance and Risk Neutrality 🇬🇧 🇧🇷

Many companies impose a risk threshold on major capital projects (one common such hurdle is a maximum acceptable probability of negative NPV). Projects that fail to meet the threshold are not usually rejected outright; rather, the project team is instructed to gather more information and perform more analyses, so as to reduce the range of economic uncertainty associated with the project. Projects are routinely delayed while unnecessary tests and analyses are conducted, thus eroding thousands or even millions of dollars from the NPV of these projects. Companies are comfortable with the notion of failed research efforts, but once a product or project moves into development, failure often becomes almost completely unacceptable. Stringent probability-of-success hurdles often result.

Unless the failure of a single project could put a firm into financial distress, companies should be risk neutral when making decisions at the project level – i.e., they should evaluate the financial aspects of a project based on the mean values of the economic metrics of interest (NPV, P/I, etc.) with no further consideration taken of the probability of success. Value-of-information (VOI) analyses should be used to determine when additional information or analysis adds value to a project and when it does not.

The key concept is this: Risk tolerance should be applied at the portfolio level, not the project level. The question to ask is not, “Am I comfortable with the risk associated with this project?”; rather, it is, “Am I comfortable with the risk associated with my portfolio of assets when this project is included?”