Question

8. Discuss the two methods used to incorporate risk into capital budgeting decisions.

Answer 1

The two methods used to incorporate risk into capital budgeting decisions are

1. Decision Tree
2. Sensitivity Analysis

Decision Tree - This is an analytical technique used in Capital budgeting to evaluate risky investment proposals involving sequential decisions. Decision tree helps the decision maker to analyze various decision points in relation to subsequent chance events and choose from the given alternatives in an objective and consistent manner. Decision tree is a graphical display or the relationship between the present and future events, decisions and their consequences. Since the investment decision problem looks like a tree with branches, this method is therefore known as decision tree.

Sensitivity Analysis - This is used in capital budgeting to measure risk. Whenever there is an uncertainty the Sensitivity Analysis plays a crucial role to determine the associated risk and uncertainty. This method evaluates a project using a number of estimated cash flows in order to provide the decision maker an insight about the variability of outcome. As future is uncertain and might contain errors due to estimates made this analysis takes care of the situation by using a several possible outcomes while evaluating a project.