Risk Analysis On Investment Decision: Capital Budgeting

1218 words - 5 pages

Capital budgeting involves planning a company’s future investments discovering feasibility whether or not to pursue the investments. A company may be lining up one or several investment options. In any case, several capital budgeting techniques are involved helping arrive at a good, sound financial investment decision. Several techniques include using net present value (NPV), internal rate of return (IRR), profitability index (PI), and equivalent annuity. However the process and the arrival of an ending result, the internal calculations and the actions from the ending result is not without risks. Shareholder stake, cash flow, or the entire company is at stake by making the wrong financial ...view middle of the document...

Thankfully, a market research report is available in the scenario. However, market research reports are as good as the parameters asked for and the company performing the analysis, if third party. The technology industry is ever-changing. In addition, SAI has international competitors each fighting for the same market share. The company performing the market research must be in tune with international finance and competition. The market research report displayed shows important and pertinent information allowing less assumption to be made. The less assumption made equates to less bias allowed to enter the proposal process. Although all assumption can’t be eliminated from predicting future events, the best mitigating element is to use the best information allowing one to make the best assumption of the future.
Second, capital budgeting involves net present value (NPV). Net present value is used to find worthwhile in future potential investments by looking at a company’s projected outflows and inflows. As a general rule, or the NPV rule, projects are considered feasible if the NPV is greater than 0; and not considered feasible if the NPV is less than 0. Importantly, the higher the NPV equates to more value for the company. In other words, value-additivity (2005, Corporate Finance) “implies that the contribution of any project to a firm's value is simply the NPV of the project.” NPV focuses much on a company’s cash flows. Projecting future cash flows can be risky since bias and exaggeration can be inserted into the equation. Its assumed money will be made in the future. But how much money will be made? Specifically, what will be the company’s cash flow? Its known future cash flows are estimated with market research reports, the use of betas, and trend analysis. Yet, even the best calculated figure must be discounted in some way for good measure. For example, (2005, Corporate Finance) “if an all-equity firm is seeking to value a risky project, such as renovating a warehouse, the firm will determine the required return, rS, on the project by using the SML. We call rS the firm's cost of equity capital”. The scenario allows the use of the market research report and the expert opinion to adjust for sound cash inflows and outflows. Evaluating the SAI’s sales volumes, marketing costs, and price per unit, the ending NPV favored W-Comm by over 10%.
Third, the internal rate of return (IRR) is another capital budgeting metric tool. The significance of IRR is the percentage rate needed to bring all cash flows to a NPV of 0 or to the capital already invested. The higher the percentage point, the larger the gap between the NPV and 0 or the money already...

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