Question

what are some of the risk factors when making decisions regarding capital projects? Provide details

Answer 1

Ans) Decision regarding capital projects are related to capital budgeting and they involve decision involving evaluation of alternative projects.The evaluation criteria are Accounting Rate of return , Payback period , Net present value mainly .

Accounting rate of return is average annual rate of earning higher the ARR more attractive is the project but the risk factor assosciated with this method is based on accounting profits rather than cash flows and it ignores time value of money.Similarly Pay back period is time taken to recover initial investments but the risk associate with it is ignores time value of money and it means it ignores the present value of future cash flows adjusted to discount factor that is a doller  earned today has a greater value than a doller earned tomorrow.NPV or net present value is the difference between the Present value of cash inflows and initial investment hence a project is accepted if Net present value is positive but a great degree of risk factor associated with this is it becomes meningless where project lives are unequal consider two projects A and B .Projects A generates NPV rs 30000 in 1 year and Project B generates NPV rs 31000 in 10 yeras hence due to difference in time it becomes incomparable we cannot say Project B is profitable because of higher NPV it adds risk if we do this.Similarly if the competing projects involves different risk it is highly risky if net present value between the projects are compared , the comaprison can only made only if the difference in risk is to be taken into considerations.There should be the possibility that an investor should evaluate the trade off between risk and return that is if an investor feels that the high NPV from a project is not high enough to compensate for higher project risk than it is not to be selected.