Describe any two methods of incorporating risk in capital budgeting decisions?
Answers
The risk arises in investment evaluation because we cannot anticipate the occurrence of the possible future events with certainty and consequently, cannot make any correct prediction about the cash flow sequence. In formal terms, the risk associated with project may be defined as the variability that is likely to occur in the future returns from the project.
The greater the variability of the expected returns, the riskier he project. Risk can, however, be measured more precisely. The most common measures of risk are standard deviation and coefficient of variation. To handle risk, there are conventional and statistical techniques, about which a brief discussion is made hereunder.
A. Conventional Techniques:
Payback period, Risk-adjusted discount rate, certainty- equivalent are the conventional techniques.
1. Payback period:
It is one of the oldest and commonly used methods for explicitly recognizing risk associated with an investment project. This method, as applied in practice, is more an attempt to allow for risk in capital budgeting decision rather than a method to measure profitability.
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Business firms using this method usually prefer short pay back to longer ones, and often establish guidelines such that the firm accepts only investments with some maximum payback period, say three of five years,
Advantages:
The merit of payback as discussed in the previous question is its simplicity. Also, payback makes an allowance for risk by i) focusing attention on the near term future and thereby emphasising the liquidity of the firm through recovery of capital, and ii) by favouring short term project over what may be riskier, longer term projects.
Limitations:
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It suffers from three major limitations.
1. It ignores the time value of cash flows
2. It does not make any allowance for the time pattern of the initial capital recovered.
3. Setting the maximum payback period as two three or five years usually has little logical relationship or risk preferences of individuals or firms.
2. Risk-adjusted discount rate:
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The more uncertain the returns it is the future, the greater the risk and the greater the premium required. Based on this reasoning, it is proposed that the risk premium be incorporated into the capital budgeting analysis through the discount rate.
If the time preference for money is to be recognised by discounting estimated future cash flows, at some risk-free rate, to their presentÂ
Explanation: