Question

Capital budgeting decisions are risky because: (1) the outcomes are uncertain, (2) large amounts of money are usually involved, (3) the investment involves a long-term commitment, and (4) the decisions may be difficult or impossible to reverse.

My question is what are the process we should use to minimize these risks?

Answer 1

Capital Budgeting:

Capital Budgeting is the process of Long term  Investment and to ensure whether the investments is worth the value that firm is going to receive.

Example will be to evaluate the returns invested in machinery or any assets.

Risk can be reduced by using conventional method of Payback

Pay back period tells us how many years it will take for a firm/company to get back the invested amount, by doing pay back liquidity position of the company can be ascertained which will be more helpful from futuristic point of view.

Risk can further be reduced by Risk adjusted discount rate,, it discounts estimated future cash flow at risk free rate to their present value

There are some statistical method also where risk can be minimized by

• Probability assignment::Its about someone opinion on a likelihood of the event which may occur or even not occur
• After probability assignment is done Expected value in terms of money is calculated. it will be multiplied by the possible events that would occur in probability
• Standard deviation and correlation can also be used.
• Sensitivity analysis to reduce risk and identify risk
• Break even analysis, determining when No profit no loss situation will occur
• Making scenario analysis

Thus all kinds of risk like market risk, corporate risk, industry risk need to be evaluated before investing on this