Boundless Finance: "Chapter 12, Section 1, Part 1: Risks Involved in Capital Budgeting"

Risks Involved in Capital Budgeting

The process of capital budgeting must take into account the different risks faced by corporations and their managers.

LEARNING OBJECTIVE

  • Identify the different risks that must be accounted for in the capital budgeting process

KEY POINTS

    • Capital budgeting (or investment appraisal) is the planning process used to determine whether an organization's long-term investments are worth pursuing. The risk that can arise here involves the potential that a chosen action or activity (including the choice of inaction) will lead to a loss.
    • There are numerous kinds of risks to be taken into account when considering capital budgeting. Each of these risks addresses an area in which some sort of volatility could forcibly alter the plan of firm managers.
    • There are different ways to measure and prepare to deal and plan for these risks, including sensitivity analysis, scenario analysis, and break-even analysis among others.

TERMS

  • risk

    The potential that a chosen action or activity (including the choice of inaction) will lead to a loss (an undesirable outcome).

  • capital budgeting

    The planning process used to determine whether an organization's long term investments, such as new machinery, replacement machinery, new plants, new products, and research development projects are worth pursuing.

FULL TEXT

Capital Budgeting

Capital budgeting (or investment appraisal) is the planning process used to determine whether an organization's long term investments, such as new machinery, replacement machinery, new plants, new products, and research development projects are worth pursuing. When taking on this planning process, managers must take into account the potential risks of the investment not panning out the way they plan for it to, for any number of reasons. In order to discuss this further, we should look into defining the concept or risk.

Risk

Risk is the potential that a chosen action or activity (including the choice of inaction) will lead to a loss (an undesirable outcome). The notion implies that a choice having an influence on the outcome exists (or existed). Potential losses themselves may also be called "risks. "

Possible Business Risks

Possible Business Risks

This chart represents a list of the possible risks involved in running an organic business. Risks such as these affect sales, which in turn affect the amount of operating leverage a company should utilize.

There are numerous kinds of risks to be taken into account when considering capital budgeting including:

  • corporate risk
  • international risk (including currency risk)
  • industry-specific risk
  • market risk
  • stand-alone risk
  • project-specific risk

Each of these risks addresses an area in which some sort of volatility could forcibly alter the plan of firm managers. For example, market risk involves the risk of losses in position due to movement in market positions.

There are different ways to measure and prepare to deal with risks as well. One such way is to conduct a sensitivity analysis. Sensitivity analysis is the study of how the uncertainty in the output of a model (numerical or otherwise) can be apportioned to different sources of uncertainty in the model input.

A related practice is uncertainty analysis which focuses rather on quantifying uncertainty in model output. Ideally, uncertainty and sensitivity analysis should be run in tandem. Another method is scenario analysis, which involves the process of analyzing possible future events by considering alternative possible outcomes.

For example, a financial institution might attempt to forecast several possible scenarios for the economy (e.g., rapid growth, moderate growth, slow growth), and it might also attempt to forecast financial market returns (for bonds, stocks, and cash) in each of those scenarios. It might consider sub-sets of each of the possibilities. It might further seek to determine correlations and assign probabilities to the scenarios. Then it will be in a position to consider how to distribute assets between asset types (i.e., asset allocation). The institution can also calculate the scenario-weighted expected return(which figure will indicate the overall attractiveness of the financial environment). It may also perform stress testing, using adverse scenarios.




Last modified: Friday, 8 April 2016, 6:34 PM