Incorporation of Project Risk in Capital Budgeting and Discounted Cash Flows

This article discusses the incorporation of project risk in capital budgeting and the use of discounted cash flows for evaluating the capital budgeting procedure. It covers topics such as payback period, risk premium, sensitivity analysis, and the advantages and limitations of discounted cash flows. The article also highlights the importance of considering variable factors and potential errors in the capital budgeting approach.

Running head: MA W5 POST
MA W5 Post
Name of the student
Name of the university
Student ID
Author note

1MA W5 POST
Table of Contents
Incorporation of project risk in the analysis of capital budgeting..............................................2
Using discounted cash flows for evaluating the capital budgeting procedure...........................2
Reference....................................................................................................................................4

2MA W5 POST
Incorporation of project risk in the analysis of capital budgeting
Capital budget is the plan to invest in long-term asset like machinery, equipment or
building. Risk in these investments are unavoidable and various risks include the risk of
investee company will liquidate, non-payment of cash flow on time or sinking of the funds
through investing the fund in risk associated projects. However, through incorporation of risk
in the capital budgeting procedure the investors can minimize the losses. Risk in the capital
budgeting can be incorporated through following –
 Payback period – it is the time taken by the project to cover up the amount of initial
outlay. The investor generally sets the time limit at which he prefers to receive the
returns. The project that provides returns beyond the time limit preference set by the
investor is considered to be risky (Bierman & Smidt, 2014).
 Risk premium – as the investors wants to avoid risk, therefore to encourage them for
investing into the risky projects, returns from these projects shall be higher as
compared to the returns from the projects those involve lower risks like treasury
bonds. Risk premium is the discount rate added to risk free rate of the borrowing. The
investment that offers maximum return is chosen.
 Sensitivity analysis – return on investment for the project is impacted by various
factors like cost of the sales, rate of tax, investment and sales. Changes in the level of
cash flow owing to changes in these factors are measured through sensitivity analysis.
It involves the process of recognizing the factors that have impact on the cash flows
and it establishes the mathematical relationship among these factors through
analyzing the changes in these factors with regard to the cash flows. If the cash is
sensitive to the changes in any factor the project will be considered as risky (Rossi,
2014).
Using discounted cash flows for evaluating the capital budgeting procedure
Discounted cash flow is used for valuing a project on the basis of time value of the
money. Through the discounted cash flows the future value of the cash flows are discounted
for determining the value of the project today is worthwhile. Advantages of using the
discounted cash flows in the process of capital budgeting are as follows –

3MA W5 POST
 Using the discounted model the investor can analyze the amount of cash that will be
received by him after paying – off the obligations.
 Projections – it helps in true projections of the money left for the investors
irrespective of the cash outflow is segregated as operating expenses or capitalized as
asset (Vlaović-Begović, Momčilović & Jovin, 2013).
 Business strategy – it enables the investors to make the key changes in business
strategies under the valuation model that will not reflect as per any other valuation
model.
Major drawback of the model is that it assumes the capital cost or interest rate will not
vary. Another issue with the model is that it assumes that the cash flow will be projected
accurately. In reality these factors are variable and not considering this fact will increase the
chances of the errors (Ehrenmann & Smeers, 2013). However, inspite of these drawbacks the
discounted cash flow is considered as important measure for capital budgeting approach
owing to the above mentioned advantages.

4MA W5 POST
Reference
Bierman Jr, H., & Smidt, S. (2014). Advanced capital budgeting: Refinements in the
economic analysis of investment projects. Routledge.
Ehrenmann, A., & Smeers, Y. (2013). Risk adjusted discounted cash flows in capacity
expansion models. Mathematical Programming, 140(2), 267-293.
Rossi, M. (2014). Capital budgeting in Europe: confronting theory with
practice. International Journal of Managerial and Financial Accounting, 6(4), 341-
356.
Vlaović-Begović, S., Momčilović, M., & Jovin, S. (2013). Advantages and limitations of the
discounted cash flow to firm valuation. Škola biznisa, (1), 38-47.