What Is the Role of Risk in Capital Budgeting?

A business’s capital budget is its strategy for generating the projects and ideas that fund the company. The meaning of risk is different depending on the context, even when discussing risk in conjunction with capital budgeting. Generally, business risk means spending company funds on a project, or investment, that may or may not yield revenue. With risk in capital budgeting, the term means the calculation of potential financial variability in revenue from a project or idea.

Risk in capital budgeting has three different levels: the project standing alone risk, the project’s contribution-to-firm risk, and systematic risk. Standing alone risk measures a project’s potential without factoring in the potential risk the new projects adds to the company’s existing assets and other projects. Contribution-to-firm risk factors in the project’s potential effect on other projects and assets. Analyzing systematic risk means considering the project from the shareholders’ viewpoint.

Standing alone risk and contribution-to-firm risk in capital budgeting for stock-trading corporations are only used as considerations and starting points for risk calculation. For the most part, financial managers are primarily interested in systematic risk. Relying on standing alone risk calculations is impractical because a project’s risk is almost always diversified across the company. Depending on contribution-to-firm risk factors is a bit more realistic, but the risk to shareholders often ends up lost in the diversification.

Shareholders’ investments constitute a vital portion of a corporation’s funding. A shareholder usually requires the company to make revenue, pay dividends, and appear financially healthy enough to keep the stock price relatively high. Increasing revenue and maintaining financial health is extremely beneficial for the corporation as well, so systemic risk is the most often used calculation of risk in capital budgeting. If a company doesn’t offer stock or have shareholders, then financial managers use contribution-to-firm risk calculation.

Financial managers may incorporate systematic risk into capital budgeting using one of two strategies: the certainty equivalent approach or the risk-adjusted discount rate. The certainty equivalent approach calculates risk by theoretically removing risk from cash flows, then predicting how much cash could be spent and what it could spent on. Finally, the financial manager discounts the cash flows back to the present, with the potential expenditure equaling the risk. The risk-adjusted discount rate uses expected rate of return calculations to adjust capital expenditures by recalculating and adjusting at regular intervals, or when the company considers adding new projects.