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“It is worth noting that the discretionary spend at the end of year two has also been discounted at the 11% cost of capital. Although this is the approach commonly taken it could be more accurate to discount such discretionary expenditure at the risk free rate. This is because discretionary expenditure has much less operational risk than the net cash inflows that it is hoped will arise from such expenditure”, AFM technical article.
could you explain how the discretionary spend has less operational risk? could it be the fact that it is not vital in the continuation of the project reduces the expected return than the cost of capital. and/or as this cash is readily available,and if not used in the project, it will just earn us the interest(which will be forgone should the money is used in the project) which is presumed to be the risk free rate?
thanks,john.Latest article under the heading “using real options when making financial strategy decision”. The section B split of the syllabus.
The risk it is thinking about is the risk attaching to the cash flows. Most flows are at risk because they actual flow might turn out to be higher or lower. The more uncertain we are about the flows then the more risky they are.
Here, we are certain about what the discretionary expenditure will be and so there is no risk of it being higher or lower.
(I wouldn’t be too worried about this article because it has not been written by the examining team 🙂 )
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