Hello,
I need three responses of at least 200 words each for the below students discussions for this week. Also in the bold below are the questions the students at answering.
In 300 words, discuss how a projectâs risk can be incorporated into capital budgeting analysis. Should discounted cash flows be used to evaluate capital budgeting projects?
Student one:
A capital budget is a plan used for investing in long-term assets, such as buildings and machinery. With that, risk is always associated with these types of investments and can include things such as cash flows being paid late, the investee company failing or even the management putting the invested funds into overly risky projects. When a company works to incorporate an understanding of these risks in their capital budgeting, the possible risks associated can be minimized. One way that investors can try to entice others to invest in their projects that are considered to be a higher risk is to offer the projects that are presumed to have a higher return versus the less risky projects. A risk premium is a discounted rate that is added to the risk-free rate of borrowing. This risk-free rate is defined as the rate of return on a low-risk investment, for example a government-backed security. The investments are then appraised using the resulting discount rate and the investments that present a better return are the ones selected (Adams, 2016).
Another aspect of capital budgeting is the concept of cash flows. This concept is used to establish an estimate which is used to determine the economic viability or the long-term investments. The cash flows of a project are estimated using the discounted and non-discounted cash flow methods. Discounted cash flow (DCF) are used as a method to account for the time value of money when determining the viability of future projects. This time value changes the purchasing power of the dollar over time. Similarly, the net present value (NPV) is a concept that presents the difference between an investmentâs present value of cash inflows and its present value of outflows. These cash flow estimates are then determined using a market-based discount rate, or hurdle rate, which is used to account for the time value of money (Cole-Ingait, 2017).
References
Adams, D. (2016, October 26). The Best Ways to Incorporate Risk Into Capital Budgeting. Retrieved from https://smallbusiness.chron.com/ways-incorporate-risk-capital-budgeting-15317.html.
Cole-Ingait, P. (2017, November 21). Capital Budgeting: Estimating Cash Flow & Analyzing Risk. Retrieved from https://smallbusiness.chron.com/capital-budgeting-estimating-cash-flow-analyzing-risk-71904.html.
Student two:
Risk is critical when analyzing a capital budget. Risk must be analyzed thoroughly for investors to minimize any potential losses (Adams, 2019). When analyzing a capital budget, the firm must be mindful that projects with higher risk levels will require higher returns to the projectâs investors. In addition, establishing a payback timeframe is important to know when returns are expected. If it is determined that returns may not occur for long periods of time, or maybe not at all, then the project would be considered high risk and may not proceed. Estimated future cash flows are also determined to âpredictâ the probability of a certain cash flow (Adams, 2019). This can be done by using a certainty-equivalent coefficient multiplied by the uncertain cash flow. Those projects with low certainty equivalent ratings will be the riskiest investments. Another way the risk that capital budgets are analyzed is by analyzing sensitivity based on sales, tax rates, and other costs. If the cash flow may be affected by those factors, the project is deemed risky. Sensitivity analysis can be challenging, however, if multiple factors may be expected to change (Drake, 2007). Once the risks are assessed, businesses must determine the impact on the ownersâ wealth and the general welfare and profits of the business (Drake, 2007).
Discounted cash flows should be used to evaluate projects because it is the most accurate method companies can use to make these predictions and to assess risk. By discounting the cash flows, we can differentiate between what a company is worth today compared to what it could potentially be worth in the future. Value is expected to increase and therefore, the cash flow is discounted to determine risk and profitability (Chen, 2019).
Adams, D. (2016, October 26). The Best Ways to Incorporate Risk Into Capital Budgeting. Retrieved from https://smallbusiness.chron.com/ways-incorporate-risk-capital-budgeting-15317.html.
Chen, J. (2019, December 4). Understanding Discounted Cash Flow (DCF). Retrieved from https://www.investopedia.com/terms/d/dcf.asp.
Drake, P. (2007). Module 6: Capital Budgeting. Retrieved from http://educ.jmu.edu/~drakepp/principles/module6/.
Student three:
Capital budget comes into play in a business when a company needs to evaluate the cash inflows and outflows of a significantly large project or investment. (Kenton, 2019) This method helps the managers determine which of the many investments or project will have a greater profit within a period of time. (Kenton, 2019) Any time a company is investing in new areas of their business there will be risk involved. The main purpose of completing the analysis is to see how great of a project risk it will be. If the numbers show more outflows than inflows it probably would not be wise to invest the money or time with that project. Many different things can contribute to a projects risk, for instance, the project not having profit after a long period of time due to company errors and poor choice of businesses that have no expertise, or even the international market. (Rodeck, n.d) With the unexpected economies fluctuating, more investors tend to want to be safer about the decisions they are making. Having a risk premium can entices investors because of a discount to the risk-free-rate in borrowing. (Adams, n.d)
While a discount rate can assist in getting investors comfortable enough to invest, it is important to take caution in the discounted cash flow of a project that is having a capital budgeting analysis. (Kenton, 2019) It is great to know how the future cash flow is discounted to determine if a project is worthwhile. It becomes an issues on long term determination be the models of discount cash flow are based on no fluctuation in interest rate or situation like errors or wrong choices. Basing your project only on discounted cash flow can definitely give false numbers because it does not include the possible risk. (Kenton, 2019) Instead of a first and only choice of capital budgeting analysis, it can be used to give a roundabout short term determination. Using the Throughput Analysis can give more realistic results if done correctly. Throughput analysis provides managers with mainly the operating expenses to continue the project through the errors and bottlenecks that may occur. (Kenton, 2019)
V/r,
Amanda
Adams, Daphne. (n.d.). The Best Ways to Incorporate Risk Into Capital Budgeting. Small Business Chron.com. Retrieved from http://smallbusiness.chron.com/ways-incorporate-ri
Kenton, W. (2019, June 26). Capital Budgeting. In Investopedia. Retrieved from https://www.investopedia.com/terms/c/capitalbudget
Rodeck, D. (n.d.). What Factors Increase the Riskiness of a Capital Budgeting Project?. In Chron. Retrieved from https://smallbusiness.chron.com/factors-increase-r
