Risks Involved in Capital Budgeting
Read this section and pay attention to the risks associated with capital budgeting. Why is it important to understand and apply risk in capital budgeting? Risks can include operational risks, financial risks, and market risks. The process of capital budgeting must consider the different risks faced by corporations and their managers.
The process of capital budgeting must take into account the different risks faced by corporations and their managers.
LEARNING OBJECTIVE
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Identify the different risks that must be accounted for in the capital budgeting process
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
- risk
The potential that a chosen action or activity (including the choice of inaction) will lead to a loss (an undesirable outcome).
- 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.
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 taking on this planning process, managers must take into account the potential risks of the investment not panning out the way they plan for it to, for any number of reasons. In order to discuss this further, we should look into defining the concept or 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 having an influence on 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 in different crops at a time. |
| Farmers sell their production to other buyers |
Offer farmers an attractive price and pay immediately, build loyalty by involving the farmers in your business. Try to understand how the other buyers are competing with you, and whether It Is temporary or permanent. |
| Theft | Rent a store with a proper door and look have it guarded. |
| Quality deterioration during storage (insect infestation, moulds etc.) | Chose suitable storage facilities, keep the place clean, dry and Windows meshed. Monitor pests with traps. Regularly take product samples and check them. |
| Product getting wet, dirty, or damaged during transportation |
Use a reliable transport service. Make sure that the truck is clean, that nothing else is boded 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 (lake photos). Make sure that 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 vie bank accounts, involve farmer organisations in handling the payments to farmers. |
| Margins are not sufficient to cover operational costs |
Increase efficiency, reduce production costs per unit. Calculate with leeway for unforeseen costs and sufficient target margins. |
| No bans can be obtained to maintain cash flow |
Organise trade loans in time, agree with farmers and clients when payments are to be made. |
| The buyer does rot pay, or pays less after having received the product |
Know and trust your client (track record), work with FOB, Letters of Credit, CAD with your preferred bank. Send correct samples, have a good agreement on handling discount. |
| 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 info local-egional markets, look into storing. |
| Clients do not honour 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 price or better quality |
Continuously work on reducing production costs and improving quality. Be more reliable than the competition. When it is structural, shift focus, diversify. |
| Sudden increase in beat price |
Cowman bate 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, the second payment depending on the realised sales price. |
| Fluctuations in exchange rate |
Negotiate sales prices in local currency or in a relatively staple currency (e.g. OUR); sell tank to back. (see next paragraph). |
Possible Business Risks: This chart represents a list of the possible risks involved in running an organic business. Risks such as these affect sales, which in turn affect 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 in position due to movement in market positions.
There are different ways to measure and prepare to deal with risks as well. 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 rather on quantifying uncertainty in model output. Ideally, uncertainty and sensitivity analysis should be run in tandem. Another method is scenario analysis, which involves the process of analyzing possible future events by considering alternative possible 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 in a position 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.
Source: Boundless
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