Risk analysis and stand-alone risk in capital budgeting decisions

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:

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.

Through operations of a competent management in an organization, any of the capital budget decision is simplicity itself. This is because while making risk analysis, the management is able to determine the upfront cost of a project. Moreover, the analyst is able to determine the periodic future, cash flows that might emerge with the operations of the project (Ehrhardt & Brigham, 2010). The important issue to note in the relationship between capital budgeting and risks is that the cash flows that the analyst manages to determine are used to evaluate the remaining present worth of the project (NPV) of the concerned project (Moyer, McGuigan & Kretlow, 2009). This is done while using the organizations weight-average cost-of-capital (WACC) as a discount rate (Brigham, Garpenski & Daves, 2010). The other use of the cash flows is to compute the Interior Rates of Return (IRR) utilized for the project (Brigham, Garpenski & Daves, 2010). After making the calculations, the results might indicate that the NPV is positive. The results might also indicate that the IRR is more than the amount achieved in WACC. The two results indicate that the organization is eligible of making decisions of whether to undertake the project or otherwise it will not (Brigham, Garpenski & Daves, 2010).

Conclusion

Many organizations tend to have various difficulties in making the recommended capital budget decisions. The difficulties arise because of failure in determining the upfront costs and the periodic cash flows. Other analysts tend to have difficulties in determining the proper WACC. In order for the organization to meet its set financial objectives, all of these quantities ought to be estimated. There is a high probability that all the estimates may contain some degree of uncertainty. This is because the process of making the estimates is inherently risky. All of the three quantities represent statistical techniques that can aid in determining the risk associate with capital budget.