How to Reevaluate Risk in the New Normal

As we emerge from the COVID-19 pandemic, many business owners and managers are grappling with the prospect of a “new normal.” Although the post-pandemic business climate will take time to fully understand, companies are already encountering a variety of new or altered risk factors. Financial experts are well-suited to help business owners get a better handle on risk when evaluating operating and capital budgeting decisions.

Measuring Risk in Today’s Landscape

The pandemic has altered the risk landscape for most businesses. In some cases, the pandemic created new risks by permanently changing the way we live and do business. For example, greater reliance on a remote workforce has lowered fixed business expenses and ushered in opportunities for companies to offer more flexible work schedules. But remote working arrangements also bring new cybersecurity and HR challenges.

In other cases, the pandemic may have increased existing risks. For instance, the pandemic highlighted cybersecurity and concentration risks with vendors, as well as risks associated with a global supply chain. Other companies may face less risk than before the pandemic. For example, competitive risks may have lessened if major competitors went out of business or relocated during the pandemic.

Factoring Risk into Operating Decisions

In today’s unprecedented market conditions, outside financial experts can help business owners identify and evaluate risks and incorporate them into their decision-making. Financial experts are experienced in assessing a variety of risks when valuing a business or calculating lost profits damages using the income approach.

For instance, when using discounted cash flow (DCF) analyses, a financial expert considers industry, market and company-specific risks to determine the discount rate. This rate is then used to calculate the present value of projected cash flows. Higher discount rates generally equate with higher levels of risk and lower values.

Similarly, DCF models can help business owners make operating decisions that reduce the company’s risk and enhance its value. For example, management may take action to reduce company-specific risk factors, such as a lack of management depth, an inferior business location, a concentrated customer base or increased competition. Over the long run, reducing risk factors can add value to the business.

Analyzing Investment Alternatives

DCF models also can help business owners make capital budgeting decisions. Typically, decisions about whether to pursue a project — such as building a new factory, hiring a new salesperson or launching a new product line — are based on whether expected returns will clear a “hurdle” rate. When considering multiple capital budgeting alternatives, management prioritizes projects by the extent to which their expected returns exceed management’s hurdle rate.

A hurdle rate is the minimum return required to compensate an investor based on the level of risk involved. Often, companies use their weighted average cost of capital (WACC) to establish the hurdle rate. In simple terms, WACC is the risk-adjusted average rate of return of a business’s lenders and investors.

Financial experts also commonly use WACC to determine the discount rate used to value a business or discount lost profits to present value. Determining an appropriate discount rate when calculating lost profits damages requires an expert to consider risks associated with the product or business line that was damaged, which may be higher or lower than the company’s overall risk level.

Similarly, a capital investment may have a different risk profile than the business’s other activities. For instance, entry into new product lines or foreign markets may involve greater risk and, therefore, require the business to clear a higher hurdle rate.

Looking Forward

In the new normal, historic hurdle rates may no longer be relevant. Financial experts can help businesses navigate in this new environment and make informed decisions based on their current risk profiles.