How do we consider risk in a capital budgeting decision?
• Risk simply refers to the uncertainty of estimated cashflow. The less certain estimates of future cashflows, the greater is the risk attached to these cashflows. From a practical standpoint, risk can be built into the analysis in many ways. • Previously, we discussed managing risk for operational budgeting. The same procedures can be applied to capital budgeting. The cashflows can be varied to determine the impact on the net present value of different cashflows. A range of cashflows can be used to estimate the impact of assorted forecasting errors. We call this sensitivity analysis. • A systematic (overall) approach to risk can be provided by increasing the discount rate. When uncertainty cannot be isolated to particular cashflows, the application of a systematic discount rate to all cashflows is appropriate. • The idea is if the chances of not receiving monies as planned are greater with riskier (uncertain) projects, these riskier projects need to return more money on average to com
