(222)---RISK ANALYSIS IN CAPITAL BUDGETING

Summary Two – Risk analysis in capital budgeting

• Simulation analysis overcomes the limitations of sensitivity or scenario analysis. The analyst specifies probability distributions for variables and computer generates several hundred scenarios, probability distribution for the projects’ net present value along with the expected net present value and standard deviation.
• Yet another technique of resolving risk in capital budgeting, particularly when the sequential decision making is involved, is the decision tree analysis. The decision tree provides a way to represent different possibilities so that we can be sure that the decisions we make today, talking proper account of what we can do in the future.
• To draw the decision tree, branches from points marked with squares are used to denote different possible decisions, and branches from points marked with circles denote different possible outcomes. In a decision tree analysis, one has to work out the best decisions at the second stage before one can choose the best first stage decision.
• Decision trees are variable because they display links between today’s and tomorrow’s decisions. Further, the decision maker explicitly considers various assumptions underlying the decision. The use of decision tree is, however, limited because it can become complicated.
• One important theory, which provides insight into risk handling in capital budgeting, is the utility theory. It aims at including a decision maker’s risk preferences explicitly into the capital expenditure decision. The underlying principle is that an investor prefers a higher return to a lower return, and that each successive identical increment of money is worthless to him than the preceding one. The decision maker’s utility function is derived to determinate the decision’s utility value.
• The direct use of the utility theory in capital budgeting is not common. It is very difficult to specify utility function in practice. Even if it is possible to derive utility function, it does not remain constant over time. Problems are also encountered when decision is taken by group of people. Individuals differ in their risk preferences.