Risk Analysis in Capital Budgeting

Capital budgeting is used to ascertain the requirements of the long-term investments of a company.Examples of long-term investments are those required for replacement of equipments and machinery, purchase of new equipments and machinery, new products, and new business premises or factory buildings, as well as those required for R&D plans.The different techniques used for capital budgeting include:

Besides these methods, other methods that are used include Return on Investment (ROI), 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

Methods of Risk Analysis in Capital Budgeting :

The following methods are used for Risk Analysis in Capital Budgeting:

Sensitivity Analysis:
This is also known as a “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.

Explore More : What is Sensitivity Analysis?

Scenario Analysis:
In the case of scenario analysis, the focus is on the deviation of a number of interconnected variables. It is different from sensitivity analysis, which usually concentrates on the change in one particular variable at a specific point of time.

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Break Even Analysis:
The Break Even Analysis allows a company to determine the minimum production and sales amounts for a project to avoid losing money. The lowest possible quantity at which no loss occurs is called the break-even point. The break-even point can be delineated both in financial or accounting terms.

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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 first realized by F.S. Hillier. There are situations where correlation between cash flows is either complete or nonexistent.

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.

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Decision Tree Analysis: The principal steps of decision tree analysis are the definition of the decision tree and the assessment of the alternatives.

Explore More : Decision Tree Analysis

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 factors such as pricing strategy, fixed and variable costs, sequential investment, insurance, financial leverage, long term arrangements, derivatives, strategic alliance and improvement of information.

Know More : What is Risk Management?

Selection of project under risk: This involves procedures such as payback period requirement, risk adjusted discount rate, judgmental evaluation and certainty equivalent method.

Practical Risk Analysis: The techniques involved include the 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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