RISK ANALYSIS IN CAPITAL BUDGETING - Accounts and Finance for Managers

Risk Analysis in Capital Budgeting Problems

In capital budgeting decisions, the risk component of the investment is not taken into consideration. The risk which is nothing but the business risk of the investment varies from one to another, to be considered in the real world situations. The risk which is nothing but the variability in between the actual returns and expected returns. The risk in the investment has to be incorporated in the discount rate for studying the worth of the project. To incorporate the risk in the discount rate, the meaning of the term risk should be known and distinguished from the uncertainty. The risk situation is one in which the probabilities of one particular event are known but the uncertainty is the situation in which the probabilities are not known. In the case of risk situation, the future losses can be foreseen unlike the uncertainty situation.
The incorporation of the risk factor in the discount rate in accordance with the variability of the returns. If the variability of the returns are more, the investor may prefer higher return in the form of risk premium for risky project unlike in the case of government securities. The government securities are not having any variability in the returns which require the risk free return to discount only in order to know the worth of the investment but the risky projects are to be discounted only with the help of higher discount rates.
There quite number of techniques available for incorporating the risk component in the capital budgeting are follows:
Sensitivity analysis
Standard deviation
Coefficient of variation and so on.

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