Unit 6: Capital Budgeting Techniques
Risks Involved in Capital Budgeting
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From Principles of Finance by Saylor Academy, used under the CC BY 3.0 licence. Written for a general audience, not for NEPSE.
Risks Involved in Capital Budgeting
Capital Budgeting
Capital budgeting (or investment appraisal) is the planning process used to determine whether an organization's long-term investments, such as new machinery, replacement machinery, new plants, new products, and research development projects, are worth pursuing. When undertaking this planning process, managers must consider the potential risks of the investment and not pan out as they plan for it for any number of reasons. To discuss this further, we should define the concept of risk.
Risk
Risk is the potential that a chosen action or activity (including the choice of inaction) will lead to a loss (an undesirable outcome). The notion implies that a choice influencing the outcome exists (or existed). Potential losses themselves may also be called "risks."
| Possible Risks | Measures to Mitigate the Risk |
|---|---|
| Operational Risks | |
| Weather conditions or pests affect crop yields | Provide technical solutions to farmers; calculate with careful scenarios; deal with different crops at a time. |
| Farmers sell their production to other buyers | Offer farmers an attractive price and pay them immediately; build loyalty by involving the farmers in your business. Try to understand how the other buyers are competing with you and whether the situation is temporary or permanent. |
| Theft | Rent a store with a proper door and lock; have it guarded. |
| Quality deterioration during storage (insect infestation, molds, etc.) | Choose suitable storage facilities, keep the place clean and dry, and make sure the windows are meshed. Monitor pests with traps. Regularly take and check product samples. |
| Product getting wet, dirty, or damaged during transportation | Use a reliable transport service. Make sure that the truck is clean and that nothing else is loaded up. Tell them you must be informed immediately in case of an accident or breakdown. |
| Product getting damaged or lost during export shipment | Make sure that the container is well loaded (take photos). Ensure the shipment is sufficiently insured by the importer (if FOB conditions) or by yourself (if CIF conditions). |
| Financial Risks | |
| Payments to farmers disappear on the way | Handle payments via bank accounts; involve farmer organizations in handling the payments to farmers. |
| Margins are not sufficient to cover operational costs | Increase efficiency and reduce production costs per unit. Calculate with leeway for unforeseen costs and sufficient target margins. |
| No loans can be obtained to maintain cash flow | Organize trade loans in time; agree with farmers and clients when payments are to be made. |
| The buyer does not pay or pays less after having received the product | Know and trust your client (track record); work with FOB, Letters of Credit, and CAD with your preferred bank. Send the correct samples and agree on handling discounts. |
| Market Risks | |
| Demand for the product slows down; no buyer can be found | Check out market trends before entering into contracts; diversify your business. Look into local-regional markets, look into storing. |
| Clients do not honor the contracts and do not buy the committed volume | Build strong partnerships; negotiate solid contracts; arrange for alternatives, even with the buyer who did not buy. |
| Competitors offer the product at lower prices or better quality | Continuously work on reducing production costs and improving quality. Be more reliable than the competition. When it is structural, shift focus and diversify. |
| The sudden increase in local price | Communicate with your buyers in good time. Decide together whether to sit it out or cancel the contract. |
| Sales prices for the product decrease | Pay farmers in two installments, with the second payment depending on the realized sales price. |
| Fluctuations in the exchange rate | Negotiate sales prices in local currency or in a relatively stable currency (e.g., EUR); sell "back to back." |
Possible Business Risks This chart lists the possible risks involved in running an organic business. Risks such as these affect sales, affecting the amount of operating leverage a company should utilize.
There are numerous kinds of risks to be taken into account when considering capital budgeting, including:
- Corporate risk
- International risk (including currency risk)
- Industry-specific risk
- Market risk
- Stand-alone risk
- Project-specific risk
Each of these risks addresses an area in which some sort of volatility could forcibly alter the plan of firm managers. For example, market risk involves the risk of losses due to movement in market positions.
There are different ways to measure and prepare to deal with risks. One such way is to conduct a sensitivity analysis. Sensitivity analysis is the study of how the uncertainty in the output of a model (numerical or otherwise) can be apportioned to different sources of uncertainty in the model input.
A related practice is uncertainty analysis, which focuses on quantifying uncertainty in model output. Ideally, uncertainty and sensitivity analysis should be run in tandem. Another method is scenario analysis, which involves analyzing possible future events by considering alternative outcomes.
For example, a financial institution might attempt to forecast several possible scenarios for the economy (e.g., rapid growth, moderate growth, slow growth), and it might also attempt to forecast financial market returns (for bonds, stocks, and cash) in each of those scenarios. It might consider sub-sets of each of the possibilities. It might further seek to determine correlations and assign probabilities to the scenarios. Then, it will be able to consider how to distribute assets between asset types (i.e., asset allocation). The institution can also calculate the scenario-weighted expected return (which figure will indicate the overall attractiveness of the financial environment). It may also perform stress testing using adverse scenarios.
Key Points
- Capital budgeting (or investment appraisal) is the planning process used to determine whether an organization's long-term investments are worth pursuing. The risk that can arise here involves the potential that a chosen action or activity (including the choice of inaction) will lead to a loss.
- There are numerous kinds of risks to be taken into account when considering capital budgeting. Each of these risks addresses an area in which some sort of volatility could forcibly alter the plan of firm managers.
- There are different ways to measure and prepare to deal and plan for these risks, including sensitivity analysis, scenario analysis, and break-even analysis among others.
Terms
- Capital Budgeting – the planning process used to determine whether an organization's long term investments, such as new machinery, replacement machinery, new plants, new products, and research development projects are worth pursuing.
- Risk – the potential that a chosen action or activity (including the choice of inaction) will lead to a loss (an undesirable outcome).
Source: Boundless Finance, https://ftp.worldpossible.org/endless/eos-rachel/RACHEL/RACHEL/modules/en-boundless-static/www.boundless.com/finance/textbooks/boundless-finance-textbook/the-role-of-risk-in-capital-budgeting-12/the-relationship-between-risk-and-capital-budgeting-96/index.html This work is licensed under a Creative Commons Attribution-ShareAlike 4.0 License .
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