It’s not always enough to decide whether or not a project will be successful, financial constraints mean that managers often have to choose between competing projects, but setting priorities aren’t always rigorously set.
“When it comes down to the final decision, especially when hard choices need to be made among multiple opportunities, they resort to less rigorous means—arbitrarily discounting estimates of expected returns, for example, or applying overly broad risk premiums,” write Martin Pergler and Anders Rasmussen for McKinsey & Company.
To make better choices about capital allocation, Pergler and Rasmussen recommend a few techniques common in the oil and gas industry, where companies often have to choose between an array of similar medium size projects.
Capital Allocation: Assess your current situation
Before you can really decide which new projects to take on, it’s important to understand where your finances currently stand. Pergler and Rasmussen think that this step isn’t forgotten so much as taken for granted. Managers are confident that they already understand what their company is doing now, but without breaking down the details you can’t say for certain whether a specific project will take you past your risk appetite.
Capital Allocation: Use consistent criteria
This is especially true when different people are presenting or advocating for projects that compete for limited resources. In order to make a fair side-by-side comparison, all projects need to have their risk profile presented in a consistent manner. A combination of NPV distribution, key risk metrics, and explicitly stating different risk exposures is a good baseline for an at-a-glance risk profile.
“A corporate-finance purist might challenge the idea of a probability distribution of discounted cash flows and the extent to which a chosen discount rate accounts for the risk already, but in practice, simplicity and transparency win over,” write Pergler and Rasmussen.
Capital Allocation: Prioritize by risk-adjusted returns
Arguments about which projects should get the green light can be simplified by risk-adjusted rankings that divide all projects into a couple of different groups. Any project that falls below its cost of capital can be quickly eliminated. Similarly, a fast-track hurdle for the highest risk-adjusted returns will give push some projects through the approval process quickly. For everything in between, ranking according to risk-adjusted returns lets you know which projects can go ahead and start now (soft-capital limits) and which ones are subject to additional sources of financing or changing circumstances. This focuses the debate on marginal cases where it belongs.