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Capital budgeting involves calculating the potential financial variability in revenue from a project or idea. The risk has three levels: independent risk, risk of contribution to the company, and systematic risk. Financial managers are primarily interested in systematic risk, which can be incorporated using the certainty-equivalent approach or the risk-adjusted discount rate.
A company’s capital budget is its strategy for generating the projects and ideas that finance the company. The meaning of risk is different depending on the context, even when risk is discussed in conjunction with capital budgeting. In general, business risk means spending company funds on a project or investment that may or may not generate income. With risk in capital budgeting, the term means the calculation of the potential financial variability in revenue from a project or idea.
The risk in the capital budget has three different levels: the independent risk of the project, the risk of contribution of the project to the company and the systematic risk. Independent risk measures the potential of a project without taking into account the potential risk that new projects add to the company’s existing assets and other projects. Risk factors contributing to the company in the potential effect of the project on other projects and assets. Analyzing systematic risk means considering the project from the point of view of the shareholders.
Stand-alone risk and business contribution risk in capital budgeting for public limited companies are only used as considerations and starting points for the risk calculation. For the most part, financial managers are primarily interested in systematic risk. It is not practical to rely on independent risk calculations because the risk of a project is almost always spread out across the company. Depending on the risk factors contributing to the company is a bit more realistic, but the risk to shareholders often ends up lost in diversification.
Shareholder investments are a vital part of financing a corporation. A shareholder typically requires that the company generate income, pay dividends, and appear financially healthy enough to keep the share price relatively high. Increasing revenue and maintaining financial health is also extremely beneficial to the corporation, which is why systemic risk is the most widely used risk calculation in capital budgeting. If a company does not offer shares or has shareholders, financial managers use the company contribution risk calculation.
Financial managers can incorporate systematic risk into capital budgeting using one of two strategies: the certainty-equivalent approach or the risk-adjusted discount rate. The equivalent certainty approach calculates risk by theoretically removing risk from cash flows, and then predicting how much cash could be spent and what it could be spent on. Finally, the financial manager discounts the cash flows to the present, with the potential expense equalizing the risk. The risk-adjusted discount rate uses calculations of the expected rate of return to adjust capital expenditures by recalculating and adjusting at regular intervals, or when the company considers adding new projects.
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