The Role of Risk in Capital Budgeting

Approaches to Assessing Risk

Some quantitative definitions of risk are grounded in statistical theory and naturally lead to statistical estimates, but some are more subjective.

There are numerous important and applicable approaches to assessing risk in capital budgeting.

Since planned actions are subject to large cost and benefit risks, proper risk assessment and risk management for such actions are crucial to making them successful. As risk carries so many different meanings, there are many formal methods used to assess or to "measure" risk. Some quantitative definitions of risk are well-grounded in statistics theory and lead naturally to statistical estimates, but some are more subjective. For example, in many cases, a critical factor is human decision-making. One can say that in the realm of capital budgeting and corporate finance, both types of risk assessment are crucial.

Inspecting Equipment Risk can be assessed in several ways and is a critical step in capital budgeting and planning, as well as project management.

The field of behavioral finance focuses on human risk aversion, asymmetric regret, and other ways that human financial behavior varies from what analysts call "rational." Risk, in that case, is the degree of uncertainty associated with a return on an asset. In enterprise risk management, a risk is defined as a possible event or circumstance that can negatively influence the enterprise in question.

Its impact can be on the very existence, the resources (human and capital), the products and services, or the enterprise's customers, as well as external impacts on society, markets, or the environment. In a financial institution, enterprise risk management is normally thought of as the combination of credit risk, interest rate risk or asset liability management, market risk, and operational risk.

In project management, risk management can include planning how risk will be managed, assigning a risk officer, maintaining a database of live risks, and preparing risk mitigation plans. Risk assessment is an integral part of risk management in general and includes probability studies and the impact of events. It considers the effect of every known risk on the project and the actions needed to resolve these issues, should they occur.

In the more general case, every probable risk can have a pre-formulated plan to deal with its possible consequences. From the average cost per employee over time, or cost accrual ratio, a project manager can estimate the cost associated with the risk, if it arises, by multiplying employee costs per unit time by the estimated time lost (cost impact, C where C = cost accrual ratio * S), the probable increase in time associated with a risk (schedule variance due to risk, Rs where Rs = Probability * S). 

Sorting on this value puts the highest risks to the schedule first. This is intended to cause the greatest risks to the project to be attempted first so that risk is minimized as quickly as possible. However, this can be slightly misleading as schedule variances with a large P (probability) and small S (estimated time lost) and vice versa are not equivalent. (For example, the risk of the RMS Titanic sinking vs. the passengers' meals being served at slightly the wrong time.)

The probable increase in cost associated with risk (cost variance due to risk, Rc where Rc = P*C = P*Cost Accrual Ratio*S = P*S*CAR): sorting on this value puts the highest risks to the budget first, which can raise concerns about schedule variance.