Question

1. What is forecasting risk and why is it important to the analysis of capital expenditure projects? Explain how can the firm get the net present value technique to live up to its potential and before actual funding, how one can check out the project’s underlying assumptions about revenues and costs?

Answer 1

Forecasting risk is the risk associated with the forecasting of the cash flows of the business and that can make the manager taking up on the wrong decisions about selection of the project for skipping of a project.

It is important in analysis of capital budgeting because capital expenditure is highly associated with cash flow related to future and there is no accurate method of analysis of future cash flows so it can only be estimated in advance, it can never be accurately predicted, so there will always be a forecasting risk involved with capital expenditure.

Net present value technique can be helpful for the firm in order to discount the cash flows of the future at the present and it will be helpful in making a decision whether to accept the project related to future or not by certain decision making criteria associated with Net present value method.

One can check the project underlying assumptions about revenues and cost through continuous checking of cash flows which are associated with those projects and risk should also be properly analysed alongside weighted average cost of capital.