Risk and Uncertainty in Capital Budgeting
All the techniques of capital budgeting require the estimation of future cash inflows and cash outflows. But due to uncertainties about the future, the estimates cannot be exact. Hence, it is very important to take into account all the aspects of uncertainty. The following two methods are suggested for accounting for risk and uncertainty in capital budgeting.
- Risk adjusted cut off rate or method of varying discount rate.
- Certainty equivalent method.
Methods for Ascertaining Risk and Uncertainty in Capital Budgeting
1. Risk adjusted cut off rate or method of varying discount rate
The simplest method for accounting for risk in capital budgeting is to increase the cut-off rate or the discount factor by certain % on account of risk. The projects which are more risky and which have greater variability in expected returns should discounted at higher rate as compared to the projects which are less risky and are expected to have lesser variability in returns. The greater drawback of this method is that it is not possible to determine the risk premium rate appropriately and moreover it is the future cash flow, which is uncertain and requires the adjustment and not the discount rate.
Illustration 1. The Beta Company Is considering the purchase of new investment. Two alternatives investments are available (A and B) Rs. 1,00,000. Cash flows are expected to be as follows:
The company has a target return on capital at 10%. Risk premium rates are 2% and 8%. For investments A and B. which investments should be preferred?
Solution: The profitability of the investments can be compared on the basis of net present value of cash inflows adjusted for risk premiums rate as follows:
As even at a higher discount rate investment B gives a higher present value, so company should go for investment B.
2. Certainty Equivalent Method
Another simple method of accounting foe risk n capital budgeting is to reduce the expected cash flows by certain amounts. It can be employed by multiplying the expected cash flows by certainty equivalent co-efficient as to convert the cash flow to certain cash flows.
Illustration 2. There are two projects X and Y. each involves an investment of Rs 40,000. The expected cash flows and the certainty co-efficient are as under:
Risk free cut off rate is 10%. Suggest which of the two projects company should accept?
Calculations of Present Values of cash Inflows
As the Net present value of project Y is more than that of Project X, the company should accept project Y.