There are different sources and perspective of risk in case of capital budgeting. The finance manager has the responsibility of handling the various types of risk that are involved in the capital budgeting process so that the company does not face any challenge in the long term.
The principal risks that are faced by the finance managers with regards to capital budgeting are the following:
Project specific risk: This type of risk may arise from decreased cash flow or income of a company in comparison to the anticipated cash flow or income due to some fault of the management.
Industry specific risk: Unanticipated scientific and industrial modifications and regulative amendments for a particular industry where the project originates may lead to this type of risk.
International risk: This type of risk may result from political risk and foreign exchange rate risk, which influences the cash flows or income of an international project
Competitive risk: Unexpected activities from competitors may result in this type of risk and this can impact the project’s cash flows and revenues
Market risk: Unforeseen developments in macroeconomic elements, for example interest rate, the GDP growth rate, as well as inflation affect every type of project, though to different magnitude.
Perspectives of risk:
A project can be looked at from three separate perspectives and they are the following:
Firm risk: Firm risk is also known as corporate risk. This denotes a share of all the risks of a firm contributed by a particular project
Stand-alone risk: This refers to the risk of a project at the time it is considered in isolation.
Market risk: This is a type of risk, which is taken into consideration from the standpoint of a diversified investor. This risk is also known as systematic risk.
As the principal objective of a company is the maximization of shareholder value, the ultimately important factor is the risk that is inflicted on the shareholders by the project. In case the shareholders are comprehensively diversified, the most suitable measurement method of risk is the market risk analysis.
Last Updated on : 27th June 2013