Risk Management in Capital Budgeting Process
Capital investment decision, like the capital budgeting process, includes series of analysis and decision making processes that have long term impact on the company. Any investment conducted for future net cash growth by company’s management, regardless of investing in intangible or tangible assets can be described as capital budgeting. Company management has obligations towards company owners to increase company wealth. Risk has been recognized as an important component in the capital budget decision making. The future is uncertain and investments techniques that fail to recognize this fact will almost certainly lead to incorrect conclusions and erroneous recommendations. In today’s uncertain and unpredictable global market, where technical, technological and economic development speed is rapidly increasing, selection of optimal process and selection of optimal project is significantly difficult.
In many respects, capital budgeting defines an organization’s leadership. Capital budgeting decisions establish strategic priorities, allocate managers to assemble and communicate information across traditional organizational boundaries, for example, marketing, engineering, production, and accounting. The information is evaluated within a rational cost/benefit decision framework by analyzing cash inflows and outflows over time. In project selection process, corporate manager uses various criteria and methods in selecting the optimal project. Traditional or conventional evaluation capital budgeting methods are: present value, internal rate of return, profitability index and payback period. Limitation of Present Value (PV) criteria by which projects are eligible if PV is higher than investments (PV > I) is averted by Net Present Value (NPV). Main limitation of PV method is that doesn’t take into account the initial investment. NPV is the most important criteria, yet investors must be cautious because NPV...