The Components of Risk
- Project- Specific
- Competitive
- Industry-Specific
- International
- Market
Project- Specific
The cash flows of a project may be higher or lower because the projections were bunk-o or something popped up. This risk can be diversified away through a plethora of projects. Disney for example releases gob-fulls of movies a year, thus, the cash flow projection blunders can be absorbed through additional, successful movie projects. Beeeeuuuutch!
Competitive
When the competition turns up the heat (and remember if you “can’t stand the heat then develop some broader shoulders”) then the cash flows or earnings of your pet project can be negatively affected. Alternatively, when the competition does something stupid (Qwikster anyone?) the effect can be positive. “A good project analysis will build in the expected reactions of competitors into estimates of profit margins and growth, but the actual actions taken by competitors may differ from these expectations.” [i]
Industry-Specific
A great illustration of industry-specific risk is found in the business model of a video rental store. In the 80s and 90s the store rented VHS and changed as this technology gave way to DVDs. Soon, video rentals popped up in vending machines and through the mail and streaming on TVs and the video rental store owner was screwed and had to return to his job at the rubber chicken factory.
International
“This is the additional uncertainty created in cash flows of projects by unanticipated changes in exchange rates and by political risk in foreign markets.”[ii]
If I have a milkshake, and you have a milkshake, and I have a straw …
The quintessential example of International risk is when Disney’s overseas revenues were frozen due to the European war effort. The funds had to be spent in the U.K. so disney later remedied by making a slew of action films including Treasure Island [iii] overseas.
Market
Interest rates, inflation and the economy all create market risk. If I have a 4-plex on an adjustable rate mortgage and interest rates spike, my cash flow diminishes due to this market factor. Additionally, if prices increase and my business is unable to keep through top-level price hikes, again, you guessed it, the bottom line squelches like someone stepped on its toe.
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