Question 19.6: Examining Profitability, Risk, and Flexibility as Attributes...
Examining Profitability, Risk, and Flexibility as Attributes (Based on Exhibit 19.1)
Exhibit 19.1 presented the three objectives of profitability, risk, and flexibility. These are examples of attributes that are, respectively, cash flows, tangibles, and intangibles. Discuss why these are often three of the most important attributes.
Maximizing profitability using PW, EAC, and IRR measures has been the focus of Chapters 1 through 17, so it will not be discussed further here.
Minimizing risk or variability was discussed extensively in Chapter 18. The common measure was the standard deviation of the PW, EAC, or IRR value used to measure profitability.
This quantitative measure evaluates the outcomes of an alternative under an assumed set of probability distributions and states of nature.
Maximizing flexibility must be defined with care, or it will overlap with the attribute of minimizing risk. The focus of this attribute must be an alternative’s ability to accommodate unforeseen circumstances that were not part of the probability distributions used in evaluating risk.
For example, consider a building that could be built with a foundation and first three floors now but would accommodate another two floors later. Building all five floors at once provides economies of scale, but unused space is very expensive. Building in two stages allows flexibility in timing and in the exact design of the upper two floors. A probability distribution for when the space will be needed and profitability estimates for the cost of building in stages are required to calculate the risk for each alternative. The flexibility measure would cover the ability to do it later or earlier or in a different way than originally anticipated.