Capital Budgeting

Topics: Net present value, Investment, Risk Pages: 3 (657 words) Published: March 4, 2013
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 difficulty in making proper capital budgeting decisions arises as a consequence of the difficulty in determining the upfront costs, the periodic cash flows, even the proper WACC. All of these quantities must be estimated, and all of the ensuing estimates will contain some degree of uncertainty; the process in inherently risky. The different techniques used for capital budgeting include: • Profitability index

• Net present value
• Modified Internal Rate of Return
• Internal Rate of Return
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

Capital Budgeting and Risk

Uncertainties can exist when the outcome of an event is not known for certain, and when dealing with assets whose cash flows are expected to extend beyond one year, certainly, there’s element of risk in that situation. The evaluation of risk therefore depends, on decision maker ability to identify and understand the nature of uncertainty surrounding the key variables and on the other, having the tools and methodology to process its risk implications

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...
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