Question

What do you see as the greatest challenge in the capital budgeting process? What are the risks and how would you mitigate the identified risks?

Answer 1

I see forecasting of cash flows associated with a project is the biggest difficulty in whole capital budgeting process.

There is no specified procedure of accuracy in predicting the future cash flows and growth associated with it.

A bad prediction of cash inflows in future can result in skipping a good investment and a bad prediction in cash inflows can also result into selecting a bad Investment. So it needs a high level of analysis to predict the Cash flows and it can never be predicted with accuracy. So it is the difficult challenge in capital budgeting.

Three types of risk associated with capital budgeting are-

1. Stand alone risk - it is the project specific risk and it can be mitigated through better Analysis of project and having a dynamic approach in forecasting of cash flows and discount rate.

2. Corporate risk - It is risk associated with the company through external and internal factors. It can be mitigated through diversified portfolio. It can be also mitigated through having a control over the related parties.

3. Market risk- It is the risk associated whole industry and it is beyond the control of the company. It can only be minimised through staying diversified and focused. It can also be minimised through being flexible.