Page 158 - DMGT207_MANAGEMENT_OF_FINANCES

Unit 6: Capital Budgeting

Notes

Notes Risk Analysis in Practice in India

Most companies in India account for risk while evaluating their capital expenditure
decisions. The following factors are considered to influence the riskiness of investment
projects:
1. Price of raw material and other inputs
2. Price of product
3. Product demand

4. Government policies
5. Technological changes
6. Project life
7. Inflation

Out of these factors, four factors thought to be contributing most to the project riskiness
one selling price – product demand, technical changes and govt. policies.
The most commonly used methods of risk analysis in practice are: sensitivity analysis,
conservative forecasts include using short payback or higher discount rate for discounting
cash flows.

Except a very few companies, most companies do not use the statistical and other
sophisticated techniques for analyzing risk in investment decisions.

Self Assessment

Fill in the blanks:
12. In the context of capital budgeting, the term………., refers to the chance that a project will
prove unacceptable.
13. Risk is associated with the …………….of future returns of a project.

6.7 Conventional Techniques to Handle Risk

The following are conventional techniques to handle risk in capital budgeting:
 Payback

 Risk adjusted discount rate
 Certainty equivalent
These methods are simple, familiar and partially defensible on theoretical grounds.

6.7.1 Payback

Payback is one of the oldest and commonly used methods for explicitly recognizing risk associated
with an investment project. Business firms using this method usually prefer short payback to
longer one and often establish policies that a firm should accept guidelines with some maximum

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