Capital Expenditure Risk

Risk calculation and monitoring is important in capital expenditures.

A capital expenditure project requires substantial investments, which a corporation or a governmental agency typically borrows to fund. Capital expenditure risk is implicit in all long-term infrastructure projects because of the inherent uncertainty that lies in economic activities over extended periods of time. A company's top management must identify and monitor all factors influencing capital expenditure risk.

Capital Expenditure Risk Defined

Capital expenditures may include investments requiring substantial funds such as roads, bridges, stadiums or new corporate headquarters. For example, a major bank may engage in a capital expenditure project by building a new corporate office to be completed in five years. Capital expenditure risk may indicate all factors influencing the successful completion of the project, such as business partners (customers, lenders and suppliers) and economic trends. As a practical matter, the bank may need to ensure that the construction company involved in the project is reliable and has a good economic standing.

Risk Management

Capital expenditure risk management allows a firm or a governmental entity to review all loss elements that may adversely affect the successful completion of a project. An effective risk management strategy must focus on identifying, measuring and monitoring all elements that affect capital expenditure risk. Let's say the U.S. Department of Transportation wants to build a new interstate road. The department may need to ensure that lenders have sufficient cash levels and suppliers are in sound economic standing. Public officials also may need to ensure that construction companies have the appropriate staff and resources to complete the work.

Significance

Capital expenditure risk is inherent in long-term initiatives. Accordingly, it is critical to establish an effective and functional risk management process to prevent losses. As an illustration, assume the Department of Transportation does not review the internal controls and operating procedures of all business partners. If a lender files for bankruptcy after six months, the project may be suspended temporarily.

Market Risk

Capital expenditure risk usually includes market risk. Market risk, in the context of a capital (infrastructure) project, means risk of loss that may originate from changes in raw material prices. For instance, if the cost of raw materials, such as iron, steel bars and cement, is $500 million at the project start, and that estimate increases to $700 millions after three years, the $200 million difference is a market risk loss.

Credit Risk

Credit risk also may be part of capital expenditure risk. Credit risk is the risk of loss that may arise from a business partner's inability to reimburse a loan or meet other financial requirements. A business partner may default on a loan because of bankruptcy or temporary financial difficulties. If a major supplier in the interstate road project is out of business after seven months, the Department of Transportation may be unable to complete the project on time.

References

• All Business: How Risky Are Your Capital Expenditures?
• Academic Earth: Capital Expenditure Risk Analysis