Budgeting Basics and Beyond

20.14. Risk and Uncertainty

Risk analysis is important in making capital investment decisions because of the significant amount of capital involved and the long -term nature of the investments being considered. The higher the risk associated with a proposed project, the greater the return rate that must be earned on the project to compensate for that risk.

Managers must consider the interrelation of risk among all investments. By properly diversifying, the best combination of expected net present value and risk can be obtained.

NOTE

Do not automatically reject a high-risk project. For example, a new product with much risk may be accepted if there is a chance of a major breakthrough in the market. The business may be able to afford a few unsuccessful new products if one is developed for extraordinary return.

Probabilities can be assigned to expected cash flows based on risk. The probabilities are multiplied by the monetary values to derive the expected monetary value of the investment. A probability distribution function can be generated by computer.

Rule of thumb: The tighter the probability distribution of expected future returns, the lower is the risk associated with a project.

Several methods to incorporate risk into capital budgeting are

• Simulation

• Sensitivity analysis

• Decision (probability) trees

Other means of adjusting for uncertainty include

• Decreasing the expected life ...