Saturday, July 24, 2010


Conventional Techniques of Risk Analysis in capital budgeting

A number of techniques to handle risk are used by managers in practice. They range from simple rules of thumb to sophisticated statistical techniques. The following are the popular, non-conventional techniques of handling risk in capital budgeting.
  • Payback
  • Risk-adjusted discount rate
  • Certainty equivalent

These methods, as discussed below about payback first, but all of them are simple, familiar and partially defensible on theoretical grounds. However, they are based on highly simplified and at times, unrealistic assumptions. They fail to take account of whole range of the effect of risky factors on the investment decision-making.


Payback is one of the oldest and commonly used methods or explicitly recognizing risk associated with an investment project. This method, as applied in practice, is more an attempt to allow for risk in capital budgeting decision rather than a method to measure profitability. Business firms using this method usually prefer short payback to longer ones, and often establish guidelines that a firm should accept investments with some maximum payback period, say three or five years.

The merit of payback is its simplicity. Also payback makes an allowance for risk by focusing attention on the near term future and thereby emphasizing the liquidity of the firm through recovery of capital, and by favoring short term projects over what may be riskier, longer term projects.

It should be realized, however, that the payback period, as a method of risk analysis, is useful only in allowing for a special type of risk, the risk that a project will go exactly as planned for a certain period and will then suddenly cease altogether and be worth nothing. It is essentially suited to the assessment of risks of time nature. Once a payback period has been calculated, the decision-maker would compare it with his own assessment of the projects likely, and if the letter exceeds the former, he would accept the project. This is a useful procedure, economic only if the forecasts of cash flows associated with the project are likely to be unimpaired for a certain period. The risk that a project will suddenly cease altogether after a certain period life may arise due to reasons such as civil war in a country, closure of the business due to an indefinite strike by the workers, introduction of a new product b a competitor which captures the whole market and nature disasters such as flood or fire. Such risks undoubtedly exist but they, by no means, constitute a large proportion of the commonly encountered business risks. The usual risk in business is not that a project will go as forecast for a period and then collapse altogether; rather the normal business risk is that the forecasts of cash flows will go wrong due to lower sales, higher cost.

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