Methods of incorporating project risk into capital budgeting decisions

Methods of incorporating project risk into capital budgeting decisions

Capital Budgeting may be defined as the decision making the process by which a firm evaluates the purchase of major fixed assets including – building, machinery and equipment. It is a step by step process that businesses use to determine the merits of an investment project. It is a company’s formal procedure used for evaluating possible expenditures or investments that are important in amount.

Methods of Incorporating project risk into capital budgeting decisions: There are two methods are used for incorporating project risk into the capital budgeting decision process.

(1) Certainty equivalent method: It is the first method, in which the expected cash flows are adjusted to reflect project risk – risky cash flows are scaled down, and the riskier the flows, the lower their certainty equivalent values. It is a method in which uncertain cash flows are converted into certain cash flows by multiplying with a probability of occurrence such as cash flows. It is the risk-free cash flow which an investor considers equivalent to a higher but risky expected cash flow.

(2) Risk-adjusted discount rate method: It is the second procedure or method, in which differential project risk is dealt with by changing the discount rate average-risk projects are discounted at the firm’s corporate cost of capital, above-average-risk projects are, discounted at a higher cost of capital, and below-average-risk projects are discounted at a rate below the corporate cost of capital. Risk-adjusted discount rate is representing required periodical returns by investors for pulling funds to the specific property. The concept reflects the relationship between risk and return.