RISK CONSIDERATIONS IN CAPITAL BUDGETING September 19,

2019

Introduction

1. Capital budgeting is a process of identifying, analyzing and selecting investment to

determine a firm’s expenditures on assets whose cash flows are expected to extend beyond one
year. It’s an important process because capital expenditures require large investment but
limited by the availability of funds (Capital Rationing), greatly influences a firm’s ability to
achieve its financial objectives, and can become as a tool of control.

2. 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
equipment’s and machinery, purchase of new equipment 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:

(a) Profitability Index

(b) Net Present Value
(c) MIRR
(d) Equivalent Annuity
(e) IRR

3. Besides these methods, other methods that are used include Return on Investment
(ROI), Accounting Rate of Return (ARR), Discounted Payback Period and Payback Period.

Risk

4. Risk is the potential that a chosen action or activity (including the choice of inaction)
will lead to a loss (an undesirable outcome). The notion implies that a choice having an
influence on the outcome exists (or existed). Potential losses themselves may also be called
“risks.”
5. Possible Business Risks The chart below represents a list of the possible risks
involved in running an organic business. Risks such as these affect sales, which in turn affect
the amount of operating leverage a company should utilize.

1
RISK CONSIDERATIONS IN CAPITAL BUDGETING September 19,
2019

2
RISK CONSIDERATIONS IN CAPITAL BUDGETING September 19,
2019

Why Risk Analysis is an Essential Aspect in Capital Budgeting

6. For determining the validity of long-term investments, risk analysis is without equal in
terms of providing measured assessments of targeted risk factors. With today’s market
uncertainty as well as the glaring unknown of the future, safeguarding and securing your
company with expert insights regarding investment outcomes is simply the smart way to do
business.
7. For example, if your organization is part of the IT industry, then a risk analysis can be
useful to position technology-related goals with a company’s business strategies. In capital
budgeting, allocating resources towards necessary capital expenditures can result in increased
value for shareholders, but this is only applicable if a company has exercised wise investment
practices.
8. Risk analysis is, therefore, imperative in the context of long-term investment decision-
making measures. By constructing a process for appraising new opportunities, organizations
can develop long-term objectives, estimated future cash flows, and command capital
expenditures.

Different Types of Risks in the Capital Budgeting Process

9. Risk analysis can cover several different areas of risk assessment, in targeted sectors
that are pertinent to specific potential business investments. In the capital budgeting process,
each of these risks focuses on an area in which some type of unpredictability could forcibly
change the plan of managers.
10. Following are the types of risks to account for in capital budgeting:
(a) Standalone Risk
(b) Project-specific Risk
(c) Corporate Risk
(d) International Risk (inclusive of currency risk)
(e) Industry-specific Risk
(f) Market Risk

11. Also, there are three general event categories that can influence investment forecasts:
general economic conditions, industry factors, and company factors. These components are
additional circumstantial considerations that can alter how a business prepares for capital
budgeting. As the economy, trade market, and internal business factors are all subject to
frequent changes depending on current conditions; they should be included in the risk
identification process.

3
RISK CONSIDERATIONS IN CAPITAL BUDGETING September 19,
2019

Types of Risk Analysis to Help Prepare for Capital Budgeting

12. To help businesses manage the above-mentioned risks, they can perform different types
of risk analysis depending on the investment scenario and the relevancy of certain necessary
risk evaluation parameters. The following represent a few different types of risk analysis that
can assist companies in preparing for their capital budget:

13. Sensitivity Analysis

(a) 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. ensitivity analysis demonstrates model output changes according to
model input variations. A model is regarded a sensitive model with regards to an input
if altering the variable input modifies the model output. The variability of the output
(numeric or in any other form) may be quantitatively or qualitatively allocated to
various origins of input variances. A mathematical model can be outlined with the help
of a number of input elements, set of equations, variable quantities, and other
parameters, that are targeted to describe the procedure being used. Inputs are associated
with a large number of origins of uncertainty and these involve erroneous
measurements, lack of data, as well as inadequate comprehension of the propelling
forces and procedures.

(b) The models have to satisfy or fulfill the characteristic intrinsical variance of the
arrangement, for example, the happening of random events. Sensitivity analysis and
uncertainty analysis provide logical devices for portraying the uncertainties related to a
model.

(c) Sensitivity analysis is utilized for ascertaining the following:

(i) The quality of model explanation

(ii) Similarity of the model with the procedure in consideration.

(iii) The elements that largely contribute to the variation in output.

(iv) The domain in the space of input elements for which the variability of
the model is the highest.

(v) Unstable and optimal domains in the area of elements for application in
an ensuant calibration survey.

(vi) Mutual or reciprocal action between elements

4
RISK CONSIDERATIONS IN CAPITAL BUDGETING September 19,
2019

14. Scenario Analysis

(a) 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. It is a
method of assessing probable future occurrences by taking into account alternate
probable consequences or scenarios. Scenario analysis was planned to enable quality
decision making by appropriating more comprehensive conditions of results and what
they entail.

(b) For instance, in finance and economics, a commercial enterprise may try to
predict various probable outcomes regarding economy (for example slow development,
moderate development, and rapid development).It may also try to predict financial
market yields for stocks, bonds, and cash, in different scenarios.

(c) Scenario analysis takes into account sub-sets of every type of probability. In
addition, it may also search to ascertain correlations and allocate possibilities to
scenarios, as well as subsets. Scenario analysis will look at the distribution of assets
among different categories of assets, which is termed asset allocation.
The firm may also compute the scenario-weighted expected return (this number will
refer to the absolute quality of financial conditions). Counting on the complicated
nature of financial conditions, scenario analysis is regarded as a popular practice.
It is not easy to anticipate what is in the future, for the real future scenario can be totally
unanticipated. This proves to be true for the prediction of outcomes and allocation of
chances to those outcomes, and common predictions that do not pay any heed to
financial market yields.

(d) The scenarios may be patterned with the help of statistical or mathematical
formulae. For example, taking into consideration the probable variation in separate
outcomes and probable associations among outcomes

5
RISK CONSIDERATIONS IN CAPITAL BUDGETING September 19,
2019

(e) For example, a firm might use scenario analysis to determine the net present
value (NPV) of a potential investment under high and low inflation scenarios.

(f) Many scenario analyses use three different scenarios: base case, worst case and
best case. The base case is the expected scenario: if all things proceed normally, this is
what the expected outcome will be. The worst and best cases are obviously scenarios
with less and more favourable conditions, but they are still confined by a sense of
feasibility.

(g) The purpose of scenario analysis is not to identify the exact conditions of each
scenario; it just needs to approximate them to provide a plausible idea of what might
happen.

15. Break Even Analysis:

(a) 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.
(b) A break even analysis is a method, which denotes what is the ideal quantity of
production and the minimal amount of sales to guarantee that there is no monetary loss
of a project. Break even analysis forms an integral part of capital budgeting.
The least possible quantity at which there is no loss of money is termed as break even
point. In other words, the break even point for an item is the level where the whole

6
RISK CONSIDERATIONS IN CAPITAL BUDGETING September 19,
2019

amount of revenue is equivalent to the whole amount of costs related to the selling of
the item. If total revenue is considered as TR and total costs are considered as TC, the
break even point can be expressed as TR = TC.

(c) Usually, a break even point is computed for commercial enterprises for
ascertaining whether it is profitable if a suggested item is sold and the idea is in
opposition to an effort to alter a present item rather such that it may become attractive.
Break even analysis may also be utilized for the assessment of the probable
profitableness of a cost in a business based on sales. In case an item is sold at a higher
volume in comparison to the break even point, the company selling the product would
be able to attain a profit. If the item is sold under the break even level, the company will
incur a loss.

(d) The break even quantity is computed with the help of the following formula:

Break even quantity = Total Fixed Costs/Selling Price – Average Variable Costs

16. 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
non-existent.

17. Simulation Analysis:

(a) 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.

(b) It is one of the important techniques that are utilized in risk analysis in capital
budgeting. Simulation analysis is implemented for preparing a probability profile
regarding a criterion of merit by stochastically aggregating the variable values that are
associated with the opted criterion. With the help of sensitivity analysis, the sensitivity
of Net Present Value or NPV and IRR or Internal Rate of Return and many other types
of criterion of merit to changes in fundamental elements can be ascertained.

(c) It offers data like the following - In case the quantity manufactured and sold is
reduced by 1 percent, other factors remaining constant, the Net Present Value also
diminishes by 6 percent. This type of data, although helpful, cannot be sufficient with
regards to decision making. The decision-making authority also needs to have an idea
about the probability of this type of events. This data may be rendered by simulation
analysis.

7
RISK CONSIDERATIONS IN CAPITAL BUDGETING September 19,
2019

18. Decision Tree Analysis

(a) The principal steps of decision tree analysis are the definition of the decision
tree and the assessment of the alternatives.

(b) Decision Tree Analysis provides a tool to study and decide on various choices
available at a given point of time. It uses models of decisions which help to study the
possibility of an occurrence of a particular consequence. Decision Tree Analysis also
studies the cost of resources, utilities, and the chances of event outcomes.
When there are several options to choose from, Decision Tree Analysis can be a wise
alternative to choose and judge, among the various options available. They give a
structure or model that effectively investigates various probable outcomes of each
option.

(c) Decision Tree Analysis also helps to design a balanced and rational picture of
rewards and risks, that are associated with each possible optional action. There are some
rules associated with use of Decision Tree Analysis. For instance, when a business
needs to make a decision on two courses of action, the decision is represented in a small
square drawn at the left of a piece of paper. Each possible and probable solution is
written on the right hand side of the paper, along lines drawn from the square. At the
end of the lines, the results are considered. It should be noted that the lines should be
drawn keeping distance from one another, so that no problem arise later.
The results can be either decisions or uncertain decisions. If the result considered is a
decision, then another square is drawn and the same process is followed again. If the
result is an uncertain decision, then it is noted by a circle in the decision tree. The
decision is written above the circle or square. The possible outcomes resulting from the
circle are also represented by drawing lines. The entire process is repeated until the
final outcomes of the decision are reached.

8
RISK CONSIDERATIONS IN CAPITAL BUDGETING September 19,
2019

(d) This decision tree highlights the outcomes of different investing strategies.
Next to the terminal nodes is blue text with the yield and gain. Unlike a flow chart, a
decision tree consists of three types of nodes:

(i) Decision nodes – commonly represented by squares – the user gets to

decide which branch to take.

(ii) Chance nodes – represented by circles – the branch taken is determined

by probabilities.

(iii) End nodes – represented by triangles – there are no more branches

extending from the node, and the final value of the strategy is listed.

19. Monte Carlo Simulation

(a) Monte Carlo simulation uses statistical data to figure out the average outcome
of a scenario based on multiple, complex factors. By running many simulations based
on the probability or distribution of an input (x), the analyst can see the average output
(y). This is done for multiple inputs at once to find out how they affect the output.

9
RISK CONSIDERATIONS IN CAPITAL BUDGETING September 19,
2019

(b) In order to account of complex, interconnected factors, all of which may affect
financial outcomes, companies turn to statistical methods. The Monte Carlo method
solves a problem by directly simulating the underlying process and then calculating
the average result of the process. It simulates the various sources of uncertainty (eg.
inflation, default risk, market changes, etc.) that affect the value of the instrument,
portfolio, or investment in question, and calculates a representative value given these
possible values of the underlying inputs. In essence, the Monte Carlo method is
designed to find out what happens to the outcome on average when there are changes
in the inputs.

(c) Each potential factor is assigned a probability or statistical distribution. For

example, the investor may estimate the probability of default on a bond as 20%. That
means that 20% of the time, he will not earn back his principal. The investor may also
estimate that the inflation rate is normally distributed around a mean of 3% and
standard deviation of 0.5%. The investor estimates the probability or distribution of
every factor that could change the result of the investment. Then, he essentially uses
the distributions to run many simulations of all the inputs to see how they affect the
output and then finds the average output.

(d) The advantage of the Monte Carlo method is that it is able to handle multiple
moving, and possible related, inputs. As the number of factors increases, it becomes
harder to figure out the “base case.” Statistical analysis through Monte Carlo
simulations is great at handling problems with multiple, inter-related and uncertain
factors.

Assessing Stand-Alone Risk

20. Total Beta is a measure used to determine risk of a stand-alone asset, as opposed to one
that is a part of a well-diversified portfolio. Beta is a number describing the correlated volatility
of an asset or investment in relation to the volatility of the market as a whole. However,
appraisers frequently value assets or investments, such as closely held corporations, as stand-
alone assets. Total Beta is a measure used to determine the risk of a stand-alone asset, as
opposed to one that is a part of a well-diversified portfolio. It is able to accomplish this because
the correlation coefficient, R, has been removed from Beta. Total Beta can be found using the
following formula:

Total Beta = βRβR

10
RISK CONSIDERATIONS IN CAPITAL BUDGETING September 19,
2019

21. Another statistical measure that can be used to assess stand-alone risk is the coefficient
of variation. In probability theory and statistics, the coefficient of variation is a normalized
measure of dispersion of a probability distribution. It is also known as unitized risk or the

variation coefficient. In terms of finance, the coefficient of variation allows investors to

determine how much volatility (risk) they are assuming in relation to the amount of expected
return from an investment. Volatility is measured in the form of the investment’s standard
deviation from the mean return, thus the coefficient of variation is this standard deviation
divided by expected return. A lower coefficient of variation indicates a higher expected return
with less risk.

22. The coefficient of variation is a dimensionless number, meaning it is independent of

the unit in which the measurement has been taken. For this reason, it becomes useful in finance
to measure the risk of an investment in a way that it is not dependent upon other types of risk,
such as that of the overall market.

Risk and Return Considerations

23. Risk refers to the variability of possible returns associated with a given investment.
Risk, along with the return, is a major consideration in capital budgeting decisions. The firm
must compare the expected return from a given investment with the risk associated with it.
Higher levels of return are required to compensate for increased levels of risk. In other words,
the higher the risk undertaken, the more ample the return – and conversely, the lower the risk,
the more modest the return.

24. This risk and return trade-off is also known as the risk-return spectrum. There are
various classes of possible investments, each with their own positions on the overall risk-return
spectrum. The general progression is: short-term debt, long-term debt, property, high-yield
debt, and equity. The existence of risk causes the need to incur a number of expenses. For
11
RISK CONSIDERATIONS IN CAPITAL BUDGETING September 19,
2019

example, the riskier the investment the more time and effort is usually required to obtain
information about it and monitor its progress. Moreover, the importance of a loss of X amount
of value can be greater than the importance of a gain of X amount of value, so a riskier

investment will attract a higher risk premium even if the forecast return is the same as upon a
less risky investment. Risk is therefore something that must be compensated for, and the more
risk the more compensation is required.

25. When a firm makes a capital budgeting decision, they will wish, as a bare minimum, to
recover enough to pay the increased cost of investment due to inflation. Thus, inflation is a
pivotal input in a firm’s cost of capital. However, since interest rates are set by the market, it
happens frequently that they are insufficient to compensate for inflation.

26. Risk aversion also plays an important role in determining a firm’s required return on an
investment. Risk aversion is a concept based on the behavior of firms and investors while
exposed to uncertainty to attempt to reduce that uncertainty. Risk aversion is the reluctance to
accept a bargain with an uncertain payoff rather than another bargain with a more certain, but
possibly lower, expected payoff. For example, a risk-averse investor might choose to put his
or her money into a bank account with a low but guaranteed interest rate, rather than into a
stock that may have high expected returns, but also involves a chance of losing value. Risk
aversion can be thought of as having three levels:

(a) Risk-averse or risk-avoiding

(b) Risk-neutral

(c) Risk-loving or risk-seeking

12
RISK CONSIDERATIONS IN CAPITAL BUDGETING September 19,
2019

27. Beta is a measure firms can use in order to determine an investment’s return sensitivity
in relation to overall market risk. Beta describes the correlated volatility of an asset in relation
to the volatility of the benchmark that said asset is being compared to. This benchmark is
generally the overall financial market and is often estimated via the use of representative
indices, such as the S&P 500. Beta is also referred to as financial elasticity or correlated

relative volatility, and can be referred to as a measure of the sensitivity of the asset’s returns to
market returns, its non-diversifiable risk, its systematic risk, or market risk. Higher-beta
investments tend to be more volatile and therefore riskier, but provide the potential for higher
returns. Lower-beta investments pose less risk, but generally offer lower returns.

Risk Factors Impacting Capital Budgeting

28. Risk Adjusting the Discount Rate Discount rates are adjusted on an
investment to investment basis, as different investments encounter different degrees of risk that
must be considered when determining equitable returns. The discount rate is the percentage
used in a net present value calculation to understand the overall cost of capital (or, from the
perspective of some investors, the required return) on a given project.

29. Why Adjust for Risk? The primary purpose of a discount rate, or an interest rate
in general, is fairly simple. Capital today is worth more than capital tomorrow, due to the time
value of money (i.e. the opportunity cost of foregone investments). As a result of this concept,
the idea of interest rates is justified. A riskier investment will require a higher return (due to
the basic premise of risk and return). It is at this point that the logic behind adjusting discount
rates becomes practical. All discount rates must take into account the overall risk being
assumed in the investment, and adjust the rate of expected return to meet the implications of
the overall risk over time. For banks, for example, the overall interest rate they would offer a
risky entrepreneurial project isn’t the same as the rate they would offer an established big
business.

30. Risk-adjusted Net Present Value

(a) A net present value calculation is a common and useful tool that takes the
overall future projected costs and returns of a new venture or business project and
grounds it in today’s dollars. What this means is it calculates out the time value of
money during the projected time period of the financing of the project in order to see if
the returns over a given time period will exceed the costs in beginning the project.

(b) Adjusting this for the risk-adjusted discount rate is a simple modification, where
each future cash flow is multiplied by the estimated likelihood of its occurrence. In this

13
RISK CONSIDERATIONS IN CAPITAL BUDGETING September 19,
2019

situation, a higher degree of uncertainty (and thus risk) is built into each expected cash
flow (called a discounted cash flow, or DCF). Through discounting each cash flow by
the estimated probability of receiving that return, the overall riskiness of the NPV
calculation is increased. With this increase in risk, the discount rate can now be risk-
adjusted accordingly.

31. Common Risk-adjusted Discount Rates

(a) It is important to note at this point that every calculation is different, and some
start-ups will see low discount rates because investors believe strongly in what the start-
up is trying to accomplish. However, the discount rates typically applied to different
types of companies show significant differences:

(i) Early start-ups: 40–60%

(ii) More established start-ups: 30–50%
(iii) Mature companies: 10–25%

(b) Investors must carefully consider the risk in a given investment, and adjust the
discount rates accordingly. This ensures a proper assessment of the risk and return ratio
for various differentiated investment projects.

32. Risk Adjusting for the Time Horizon A longer time horizon usually
requires a higher return, due to increased price volatility and uncertainty relating to possible
outcomes. When evaluating the riskiness of an investment, not only will investors or companies
need to evaluate their preferences and risk tolerance, but it is also necessary to take into account
the time horizon of the investment. A longer time horizon will generally require a higher return,
due to an increased risk in price volatility and increased uncertainty relating to possible
outcomes. Default risk increases as the time horizon lengthens. However, when considering
stock investments, having a longer time horizon can be considered safer in some respects. Since
stock investments have more time to overcome potential downturns in value, having a longer
time horizon can justify more aggressive investing.

Real Options Consideration

33. When there are multiple possible outcomes, management of a firm may choose to
undertake real options analysis in order to factor in the various possibilities. A real option itself
is the right, but not the obligation, to undertake certain business initiatives, such as deferring,
abandoning, expanding, staging, or contracting a capital investment project. When uncertainty
exists as to when and how business or other conditions will eventuate, flexibility as to the
timing of the relevant project is valuable and constitutes optionality.

Real Options and Capital Budgeting

14
RISK CONSIDERATIONS IN CAPITAL BUDGETING September 19,
2019

34. Traditional capital budgeting theory holds that investments should be made when the
simple net present value (NPV) of an investment opportunity equals or exceeds zero. It also
assumes that the investment must be made either now or never. However, such an investment
approach fails to consider that management can adapt and revise its strategies in response to
unexpected market and technological developments that cause cash flows to deviate from their
original expectations. In other words, it fails to capture managers’ flexibility in adapting their
decisions to evolving market and technological uncertainty.

Real Options and Investment Decisions

35. A strategic implication of real options theory is that investment will be discouraged by
exogenous uncertainty. For this reason, the timing of an investment can be crucial in
determining its profitability.

36. Another value-creating aspect of real options can be found in abandonment. The
abandonment options comes into play when a firm purchases an asset that it may later resell or
put to an alternative use, should future conditions be sufficiently adverse. Availability and
recognition of this option will increase a firm’s propensity to invest relative to what would be
suggested by a simple NPV rule, which assumes that the investment project continues for its
physical lifetime and omits the possibility of future divestment.

Growth Options

37. Real investments are often made not only for immediate cash flows from the project,
but also for the economic value derived from subsequent investment opportunities. Such future
discretionary investment opportunities are known as growth options. For example, firms
usually undertake research and development investments to strategically position themselves
for the economic value from commercialization when market conditions turn favourable.

15
RISK CONSIDERATIONS IN CAPITAL BUDGETING September 19,
2019

Similarly, firms usually make foothold investments in a new foreign market for the possibility
of expansion in the future. Such growth-oriented investment may appear uneconomical when
viewed in isolation but may enable firms to capture future growth opportunities.

Conclusion

38. Risk analysis offers organizations the benefit of preparation, so that in the likelihood of
an unsavoury potential investment outcome, they are situated to deal with the event efficiently
and still survive with their business intact. Performing professional risk analysis in capital
budgeting provides identification and evaluation of risks, possible responses, and various
solutions. Depriving your company of this level of preparation, knowledge, and foresight
would be detrimental to the resilience of your business in the event of the worst-case investment
outcome. Professional risk analysis, conducted by a reputable agency can help you make
intelligent decisions that can potentially maximize your company’s wealth, value, and long-
term goals.

16
RISK CONSIDERATIONS IN CAPITAL BUDGETING September 19,
2019

BIBLIOGRAPHY

1. https://crmsindonesia.org/publications/risk-analysis-in-capital-budgeting/
2. http://www.eiiff.com/corporate-finance/risk-analysis/
3. https://courses.lumenlearning.com/boundless-finance/chapter/the-relationship-
between-risk-and-capital-budgeting/
4. https://www.wisegeek.com/what-is-the-role-of-risk-in-capital-budgeting.htm

5. https://corporatefinanceinstitute.com/resources/knowledge/modeling/what-is-
sensitivity-analysis/

6. https://www.researchoptimus.com/blog/how-risk-analysis-can-be-essential-in-capital-
budgeting/

17