Question

Capital budgeting decisions are risky. For this discussion question: Research the risks associated with capital budgeting and identify the three that you believe are the most significant risks. Describe these risks and support your assertion with specific reasons.

Answer 1

Risk means uncertainty of outcome. Risk associated with capital budgeting are:-

1. Project specific risk

It relates to the uncertainties related to a specific project. It includes error in estimation of project's cash flow, discount rate, probability of outcome etc.

2. Stand alone risk

It is basically project risk only but here we consider that the particular project is the only thing that the business does. So, the only assets, liabilities and activities that business has are related to a single project only.

3. Corporate risk

It is the risk that every corporate has to undertake. Some of the examples are chances that an employee can do fraud, change in climatic conditions, IT risks, etc.

4. International risk

This risk is only faced by those businesses which perform international transactions. Some examples are fluctuation in exchange rates, change in laws of other countries, etc.

5. Competitive risk

Risk that the competitor's can affect our demand of the product or services in return affecting our estimation of cash flows.

6. Market risk

It is the risk that the investor can lose money due to decline in value of investments due to market conditions.

The three most significant risks are:-

Stand alone risk

Corporate risk

Market risk

Stand alone risk is important because it shows the overall risk of the project considering it as a whole business. It can be measured by IRR, CV of NPV. If the business has only one core project then the stand alone risk reflects corporate risk.

Corporate risk reflect the risk of the business as whole and also it shows the impact of project on the corporate earning stability. It can be measured by Project's Corporate beta

Market risk shows the effect of the project on a well'-diversified portfolio. It can be measured by Project's beta