Capital Budgeting: Risk Analysis and Discounted Cash Flows

Capital Budgeting: Risk Analysis and Discounted Cash Flows

When carrying out capital budgeting analysis, a company must consider the various risks involved in the process such as investing shareholder funds into risky projects, collapsing of the investee company, extended periods with no payments of cash flows and so forth. Risk incorporation in capital budgeting minimizes these possibilities and can be achieved through payback period. This is the time limit set by investors for a project to offer returns. Each project is considered in terms of its cash flows and those whose returns fall beyond the time limit are considered risky and thus avoided (Fabozzi & Drake, 2009).  Another method of incorporating risk in capital budgeting is sensitivity analysis. This method evaluates the level to which an investment’s cash flows are affected by tax rates, cost of sales, investments and other critical factors. If cash flows are sensitive to such factors, the project is considered risky and avoided.

Discounted cash flows (DCF) are generally essential in determining the time value of money in an investment. Though it is the most reliable tool to mitigate accounting fraud because companies can hardly falsify their cash flows, it has shortcomings in that a small change in inputs can result in a large change in value of the company and cash flows change quite quickly (Fabozzi & Drake, 2009). This makes it unreliable for capital budgeting. It is also quite mechanical, meaning that a mistake in data input will result in misleading impressions of future cash flows. This may lead to validation/invalidation of the wrong project.

References

Fabozzi, F. J., & Drake, P. P. (2009). Capital Budgeting Techniques. Handbook of Finance.