Capital Budgeting Decision
Capital budgeting (also known as investment assessment) is the process of determining if an organization’s long-term investments, such as new machinery, replacement machinery, new facilities, new products, and research and development initiatives, are worthwhile. Managers must consider the possible risks of the investment not performing as expected for a variety of reasons when embarking on this planning process (Lumen Learning, n.d.). As a result, risk analysis in capital budgeting is critical for identifying, evaluating, and identifying solutions to diverse circumstances. Failure to do a good risk analysis jeopardizes the company’s investment outcome since it prevents it from rapidly and appropriately mitigating or eliminating the risk (Heisinger & Hoyle, n.d).
Risks Associated With Capital Budgeting
For capital budgeting, many types of risk must be addressed. According to Lumen Learning (n.d.), some of these risks are:
- corporate risk
- international risk (including currency risk)
- industry-specific risk
- market risk
- stand-alone risk
- project-specific risk
- Financial risk
In my opinion, the three risks that are the most significant are:
- Market risk: This danger is increased with a downturn in the economy. A weak economy reduces demand for the company’s goods, but high inflation reduces long-term returns and, as a result, creates a dilemma. These variables raise market risk and lead to higher overall risk (Rodeck, n.d.). I believe this is one of the significant risks because factors such as inflation and interest rates, and fluctuating markets, pose a significant danger to long-term investment.
- Project Risk: Project risk is the possibility that the project may not be as profitable as projected owing to errors made by companies or during the project’s first appraisal. When a corporation invests in a business that is outside its area of expertise, project risk increases. This raises the likelihood that management will be unable to appropriately evaluate the project’s cash flows and that the firm will make mistakes while operating (Rodeck, n.d.). In my opinion, this is one that the most “unseen” risks because sometimes the companies just try to make new projects without considering the risks just only to keep their operational activity going.
- Financial Risk: The danger of losing money on an investment or business endeavor is referred to as financial risk. Credit risk, liquidity risk, and operational risk are some of the most prevalent and different financial hazards (Hayes, 2022). I think this is also one of the most significant risks for capital budgeting because the financial risk is a sort of threat that might cause interested parties to lose money. According to Hayes (2022), these financial risks include:
- Credit Risk: The risk of borrowing money is referred to as credit risk. The borrower will default if they are unable to repay the debt. Investors who are exposed to credit risk lose revenue from loan repayments as well as principle and interest. Creditors may also see an increase in debt collection costs.
- Specific Risk: This risk pertains to a firm or a small group of enterprises and comprises a capital structure, financial transactions, and default vulnerability. The word is commonly used to describe an investor’s uncertainty about receiving returns and the associated risk of monetary loss.
- Operational Risk: The uncertainties and risks that a corporation experiences when conducting day-to-day business activities within a certain area or industry are summarized as operational risks.
Conclusion
Each of these risks covers an area where volatility might force corporate management to change their plans. There are several methods for measuring and preventing these risks. A sensitivity analysis is one such method. The management team needs to consider all the important factors such as the economic situation, the efficiency of the company’s operational activities, and other things to conduct this.
References
Hayes, A. (2022, June 4). Financial risk: The art of assessing if a company is a good buy. Investopedia. Retrieved July 25, 2022, from https://www.investopedia.com/terms/f/financialrisk.asp
Heisinger, K., & Hoyle, J. B. (n.d.). Accounting for Managers. https://2012books.lardbucket.org/books/accounting-for-managers/index.html
Lumen Learning. (n.d.). The relationship between risk and capital budgeting. Boundless Finance. https://courses.lumenlearning.com/boundless-finance/chapter/the-relationship-between-risk-and-capital-budgeting/
Rodeck, D. (n.d.). What factors increase the riskiness of a capital budgeting project? Small Business — Chron.com. Retrieved July 25, 2022, from https://smallbusiness.chron.com/factors-increase-riskiness-capital-budgeting-project-15829.html
Note:
This article is written based on University of The People Managerial Accounting (BUS 5110) written assignment by Fristy Tania in July 2022
