The Risk Adjustment of Required Rate of Return for Supply Chain Infrastructure Investments

Abstract

Abstract The purpose of this article is to apply a risk-adjusted required rate of return to evaluate supply chain capital investments. As part of the design methodology, a computer simulation provides expected cash flows resulting from alternative supply chain investments. These cash flows are discounted at a risk-adjusted required rate of return. The analysis represents a process to measure the risk inherent in supply chain investments. The logistics and supply chain literature has not addressed this problem of the risk inherent in a specific supply chain project. A corporate-wide hurdle rate applied to usually conservative supply chain investments may result in less than adequate investments in supply chain infrastructure. Prior studies have determined risk-adjusted required rate of return for the entire firm, an enterprise's entire supply chain network, but not an individual project within the supply chain. This study calculates a required rate of return for a specific supply chain investment project using a discrete simulation model rather than the more common mathematical model. Individual supply chain investment projects may have less risk or possibly more risk than reflected by a corporate hurdle rate or a supply chain hurdle rate. Using a standard required rate of return could result in too little or too much investment in supply chain facilities. In this study, when the risk-adjusted rate was employed to discount expected cash flows, only two of eleven alternatives evaluated were acceptable investments. The best investment with the highest return was a 12 percent increase in ship loading rate combined with a 33 percent increase in rail unloading capacity. It provided a benefit-cost ratio of 1.25. The limited availability of publicly traded firms that invest in supply chain projects represents a constraint, limiting the accuracy of estimating the market risk factor. Nevertheless, the practical implication is that, when making supply chain infrastructure investment decisions, it is advisable to adjust risk factors in evaluating such capital investments. This approach is preferable to using a corporate-wide hurdle rate, typically too high for such conservative investments. A firm-wide hurdle rate might result in under investment in supply chain facilities.