Risk analysis and capital budgeting decision-making

Risk Analysis Capital Budgeting

Risk Analysis in Capital Budgeting

Capital budgeting entails making various decisions in the management of an organization with the aim of determining expenditures on assets. In most cases, these particular expenditures are those that the management expects that their cash flow might extend within a period of about one year. Capital budgeting is a significant process in the management of an organization because it acts a control tool. This is because all capital expenditures that an organization expects to inquire within a certain period require large investments. However, most of these expenditures tend to be limited by availability of funds. Capital budgeting plays a significant role in influencing an organization's ability to achieve the set financial goals.

Capital budgeting and Risks

There is always a possibility of an organization to experience various uncertainties especially if the management fails to recognize the outcome of an event when dealing with assets. The element of risk occurrence is high especially when the assets have a cash flow that extends a period of more than one year. In order to curb the occurrence of various risks, the management of an organization needs to have the recommendable knowledge on the evaluations of the most expected risks (Baker & English, 2011). This means that the management ought to have the propensity to recognize and comprehend various uncertainties that might be surrounding key variables related to the expenditures. Moreover, the management ought to have the recommended tools and methodology in order to be able to process its risks implications. The management of an organization has the obligation of reflecting various risks that tend to be an obstacle in achieving financial objectives (Jackson, 2008). The most common types of risks that are separate and distinct include the following:

Stand-alone Risk

This refers to a type of risk of which the management of an organization tends to assume its occurrence. The management can, therefore, be able to develop various ideas related to a projects future cash flow. Moreover, the management can, therefore, be able to identify a number of objective probabilities associated with future cash flows. When the management of an organization manages to identify both of the above ideas, it can, therefore, be able to develop various measures of the project risks (Ehrhardt & Brigham, 2010). Stand-alone risks entail the approach where the management is able to measure the projects risks while being able to isolate all other projects related to the expenditure. In stand-alone risks, each stakeholder related to the operations of an organization tends to hold the only one stock that ought to be on risk in his/her portfolio. Moreover, stand-alone risks may occur in a situation where the organization has only the asset that is at risk. One of the significant characteristics of stand-alone risks is that it is based on various uncertainties that the management expects might emerge in relation to the project's cash flow. Another significant characteristic of stand-alone risk is that it fails to accept any of the diversifications that might be made by the organization itself or the stakeholders (Ehrhardt & Brigham, 2010). There is a possibility of management in an organization to identify the project's stand-alone risks. This can be done by evaluating the future cash flow of the project being addressed. Stand-alone risk is the easiest to measure compared with other type of risks that an organization may incur through a project's cash flows.

Within Firm Risks

This type of risks is also referred to as corporate risks (Ehrhardt & Brigham, 2010). The risk is associated with various operations of the organization itself. The management is able to make various diversifications in relation to the organization's risk. This is because this type of risk tends to identify that the project is the only asset that the organization has, in its portfolio of various projects. Another issue related to this category of entrepreneurial risk is, it fails to allow diversifications made by stakeholders related to the organization. The measurement related to the firm risk is made by identifying the project's impact in relation to the uncertainties that the organization might incur in the future in its total cash flows.

Market risks

This is the third type of risks that an organization may incur in a certain project. Market risk is also referred to as beta risk (Ehrhardt & Brigham, 2010). One of the characteristics of market risks is that it is a risk of the project identified by one of the organization's well-diversified stockholder. The stockholder manages to recognize that the project is one of the firm's operations that play a significant role in enhancing that the organization meets the set financial objectives. The stakeholder who identifies market risk also manages to identify that the firm's stock relates to the project's wealth. Another significant characteristic associated with market risks is that it is measured according to the effects that manage to make on the organization's beta coefficient.