Risk analysis in capital budgeting bears a substantial degree of importance in the field of corporate finance. Capital budgeting is an integral part of the investment decision making process of corporate finance. Capital budgeting is also known as investment appraisal.
Capital budgeting is that strategic procedure with the help of which the requirements of the long-term investments of a company can be ascertained. Examples of long-term investments are those investments that are required for replacement of equipments and machinery, purchase of new equipments and machinery, new products, new business premises or factory sheds, as well as those required for R&D plans.
The different types of techniques that are utilized for capital budgeting include the following:
- Profitability index
- Net present value (NPV)
- Modified Internal Rate of Return
- Internal Rate of Return (IRR)
- Equivalent annuity
Besides these methods, other methods that are used include Return On Investment (ROI) and Accounting Rate of Return (ARR), Discounted Payback Period and Payback Period.
The different types of risks that are faced by entrepreneurs regarding capital budgeting are the following:
- Corporate risk
- International risk
- Stand-alone risk
- Competitive risk
- Market risk
- Project specific risk
- Industry specific risk
For analyzing the risks in capital budgeting, the following methods are used:
- Sensitivity Analysis: This is also known as "what if analysis". Because of the uncertainty of the future, if an entrepreneur wants to know about the feasibility of a project in variable quantities, for example investments or sales change from the anticipated value, sensitivity analysis can be a useful method. This is calculated in terms of NPV or net present value.
Scenario Analysis: In case of scenario analysis, the focus is on the deviation of a number of inter-connected variables. It is different from sensitivity analysis, which usually concentrates on the change of one particular variable at a specific point of time.
- Break Even Analysis: If the finance manager of a company is eager to know what should be the production amount and the amount of minimum sales for assuring that money is not lost by the project, he can take the help of break-even analysis. The lowest possible quantity at which loss of money can be averted is known as break-even point. The break-even point can be delineated both in financial terms or accounting terms.
- Hillier Model: In particular situations, the anticipated NPV and the standard deviation of NPV can be incurred with the help of analytical derivation. This was opined by F.S. Hillier. There can be situations where there is no or complete correlation among cash flows.
- Simulation Analysis: Simulation analysis is utilized for formulating the probability analysis for a criterion of merit with the help of random blending of variable values that carry a relationship with the selected criterion.
Decision Tree Analysis: The principal steps of decision tree analysis are the definition of the decision tree and the assessment of the alternatives.
- Corporate Risk Analysis: Corporate risk analysis focuses on the analysis of risk that may influence the project in terms of the entire cash flow of the firm. The corporate risk of a project refers to its share of the total risk of a company.
Risk Management: Risk management focuses on the following factors, such as pricing strategy, fixed and variable costs, sequential investment, insurance, financial leverage, long term arrangements, derivatives, strategic alliance and improvement of information
Selection of project under risk: This involves the following procedures, such as payback period requirement, risk adjusted discount rate, judgmental evaluation and certainty equivalent method
- Practical Risk Analysis: The techniques involved include Acceptable Overall Certainty Index, Margin of Safety in Cost Figures, Conservative Revenue Estimation, Flexible Investment Yardsticks and Judgment on Three Point Estimates
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