The Best Ways to Incorporate Risk Into Capital Budgeting

by Daphne Adams
The increasing volatility of the global economy has caused investors to search
out safer investment alternatives. Investors use a capital budget when selecting
their investments. A capital budget is a plan for investing in long-term assets
such as buildings and machinery. Risk is inevitable to these investments. The
various risks include cash flows not being paid in time as agreed, the risk of the
investee company collapsing and also the management sinking the invested
funds in risky projects. By incorporating risk in capital budgeting, investors can
minimize losses.
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Risk Premium
Investors try to avoid risk. To encourage investors to invest their funds into risky
projects, the returns from such projects should be higher than returns from less
risky investments such as treasury bonds. A risk premium is a discount rate that
is added to the risk-free rate of borrowing. The risk-free rate is the rate of return
of low-risk investments such as government-backed securities. The investments
are then appraised using the resulting discount rate. Investments that offer better
returns are chosen.
Payback Period

[Sensitivity Analysis] Sensitivity Analysis for The time it takes for a project to pay back the amount of money invested is a
Capital Budgeting matter of concern to the investor. Investors set a time limit within which they
expect to receive returns. Each project's cash flow is determined. A project whose
return falls beyond the time limit will deemed to be risky.

Certainty Equivalent
While appraising projects, future cash flows are estimated using probability measures like forecasting techniques. These
measures do not give a true picture of future events. To avoid uncertainty, convert expected future cash flows into certain cash
flows. Certain cash flows are cash flows obtained by multiplying uncertain cash flows with a predetermined base known as
certainty-equivalent coefficient. A certainty-equivalent coefficient is factor that determines the risk associated with future cash
flows. Risky investments have a low certainty equivalent rating, hence they are avoided. This is because the probability of netting
the estimated cash flows is unlikely.

Sensitivity Analysis
A project's return on investment is affected by factors such as sales, investments, tax rate and cost of sales. Sensitivity analysis
measures the extent to which the project's cash flows change in response to changes in one of these factors. The sensitivity
analysis process involves identifying the factors that influence the project's cash flows, establishing a mathematical relationship
between these factors and analyzing how a change in each of these factors affect the project's cash flows. If a project's cash flows
are sensitive to changes in any of the above-listed factors, it is considered risky and hence avoided.
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References (5)  (#)

About the Author

Daphne Adams has been writing since 2003, with work published in the “Offshore Investment Magazine ". She holds a Master of
Business Administration from the Rotman School of Management, as well as a Bachelor of Arts in media and journalism from
Ryerson University.

Photo Credits
Comstock Images/Comstock/Getty Images

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