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Investment: can you predict the risks?

Updated Thursday, 3rd November 2011

Every investment has its own risks, but how can you assess and minimise them? Rail chief Nicola Shaw discusses tools and methods

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Janette Rutterford:
: I’d like to ask you about investment appraisal and how you go about it and what you think the key issues are when you think about investing in a project?

Nicola Shaw:
I think first you need a story; you need to know what it is you’re going to invest in, where the revenue is going to come from, how long you think it’s going to pay back so have an understanding of the project holistically. And then we do, and I have done in the past, in different range of businesses and different scale of investment, different mechanisms, use different tools for assessing the value of the investment, always you must look forward over the life of the investment, look at the revenues, discount those cashflows, usually in NPV analysis, sometimes IRR, I think it depends on what the nature of the investment is, understanding where the risks are, and that becomes quite complicated I think. What I’ve said there sounds like it’s all very simple, I actually think it’s quite a difficult process to go through.

Janette Rutterford:
: What do you do about adjusting for risk, in other words you think it might not happen the way you forecasted?

Nicola Shaw:
Yeah absolutely, there usually is a model for forecasting the revenue. So first there is sensitivities within that model, what are the driving factors behind those sensitivities and what is the scale, so identifying the key risks, or even the low probability, massive impact risk, really understanding where those things are. And then kind of it, the other things in your risk, not necessarily driving the revenue but perhaps driving your cost of capital or your own sort of banking structures or something, lots of different ways of looking at it.

Janette Rutterford:
: Do you use sensitivity in analysis or scenario analysis?

Nicola Shaw:
Always for 20 years I think I only ever saw sensitivity analysis on that. I increasingly see scenario analysis of major events I think probably since 2008 the Lehman crisis, so I think that’s changed the way people think about it, in part because nobody’s very certain about revenue at the moment.

Janette Rutterford:
: So people are doing sort of worst case scenario analysis in case something horrible goes wrong?

Nicola Shaw:
Yes but also looking at it from a different perspective of what would you do were your revenue to be one level or 20% below that, and can you flex things enough and still make the investment worthwhile?

Janette Rutterford:
: And are there any sort of subjective issues such as how the board takes these things, how they analyse projects?

Nicola Shaw:
Yeah I think that’s quite important, the way, if it’s a big investment, the way that the Chief Exec conveys us to the board can make a big difference. Does the Chief Exec believe the analysis, can they see your way of managing through those different scenarios and sensitivities, and is the board confident that the Chief Exec is taking the business in the right direction, so how their relationship has been going for some time can make a difference about big investments.

Janette Rutterford:
: And in your experience, do people go back and actually analyse whether they have made money, whether the NPV was positive in practice?

Nicola Shaw:
I think everybody wants to, some people do it better than others, and generally if you’ve got it massively wrong people would be all over you. So the importance of having the discipline in place that you’ve learnt the lessons before anything that went particularly wrong comes up is one way of defending yourself if you get it massively wrong.

Janette Rutterford:
: Thank you very much.

Nicola Shaw:
Thank you.

Nicola Shaw was talking to Janette Rutterford, of the Open University's Faculty of Business and Law, after a recording of The Bottom Line.

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