Quantifying Risk
How would you define and quantify risk as used in capital budgeting analysis?
DISCUSSION 1
Risk involves financial variables susceptibility to negative changes from planned events. According to Zemke (2015) financial plans are based on consistencies of income and liabilities. After all, the essential business function to utilize either cash on hand, or borrow money to develop a product or service to gain a greater return. Risk associated with liabilities present themselves when a business is unable to pay its liabilities, cannot acquire financing, or exposure to unfavorable interest rates.
According to Boundless.com (2015) capital budget risk can be an operational risk, financial risk, or market risk and can entail corporate risk, international risk, industry risk, market risk, stand-alone risk, or project risk. Blackman (2014) notes that measuring and quantifying risk is accomplished by determining probability and impact of potential risk.
Blackman, A (2014). How to Measure Risk in Your Business. Retrieved from http://business.tutsplus.com/tutorials/how-to-measure-risk-in-your-business–cms-22763
Boundless.com. (2015). Risks Involved in Capital Budgeting. Retrieved from https://www.boundless.com/finance/textbooks/boundless-finance-textbook/the-role-of-risk-in-capital-budgeting-12/the-relationship-between-risk-and-capital-budgeting-96/risks-involved-in-capital-budgeting-421-7545/
Zemke, J. (2010). How to measure changes in the risk states – concept of definition. Journal of Applied Business Research, 26(5), 87-95. Retrieved fromhttp://search.proquest.com/docview/750491980?accountid=35812
RESPONSE FROM THE TEACHER
You provide a satisfactory start to your discussion, but you never really address the question. You hit on capital budgeting and risk, but you do not explain how capital budgeting incorporates and quantifies risk within its framework for decision making. Hint: Look at the discount rate and/or the weighted average cost of capital…
I look forward to your elaboration on the topic
DISCUSSION 2
Businesses quantify risk through utilization of a number of ratios as either standalone ratios, compared to market standards, or as compared to competitors. At the end of the day, a certain Darwinism seems to triumph where businesses in the best financial situation stand to live longer than the competition. According to Hannon (2016) some of the quantifiable measures of business risk include Debt to Equity Ratio, or Total Debt / Total Equity, measuring a business’s financial standing and its ability to pay obligations. ReadyRatios.com (2016) adds that this ratio is industry specific where aging companies allow for predictability and may be able to assume more liabilities. Interest coverage ratio is another tool, as measured through EBIT/Interest Expense, and serves to measure a company’s ability to service debt (Hannon, 2016). A third is financial leverage ratio, or total assets / total equity, a measure which determines reliance on equity to support the business. In this sense, the measure aids in determining the disruption of an offset and reliance upon the equity base. Lastly, but not least, is the maximum Earnings decline ratio, or 1- ( 1 / Interest coverage ratio ), used to determine what the financial situation of an organization would be with a severe drop (Hannon, 2016). This tool seems useful in today’s current environment of high competition and rapid swings in market conditions, thereby increasing susceptibility to regressions or recessions. An accurate picture of risk within an organization seems to be derived not from a sole source ratio, but rather through a culmination of ratios drawing a larger picture of the state of the business and its financial condition.
Hannon, S. (2009) 4 Key Ratios to Analyze Business. Retrieved from. https://www.stocktrader.com/2009/06/22/business-risk-analysis-calculate-ratios-debt-equity-earnings-interest/
ReadyRatios.com (2016). Debt to Equity Ratio. Retrieved fromhttp://www.readyratios.com/reference/debt/debt_to_equity_ratio.html
DISCUSSION 3
Capital budgeting is a plan used to determine if an investment is worth it in the long run. There are potential risks when using capital budgeting that may arise without expecting. Risk is the potential that something will lead to a loss. Possible risks includes operations risk (weather conditions, theft, damaged products or merchandise), financial risks (consumers not paying for merchandise or service and unable to get loan(s)), market risks (demand for merchandise or service decrease and competition).
Depending on what type of business is being ran, different risks are taken into consideration. With these risks, a company can plan through capital budgeting where those risks are factored in the analysis.
There are ways to face risk factors in capital budgeting. There’s an article I read called “Techniques to Face Risk Factor in Capital Budgeting Decisions/Financial Management” (the link is below). It states 2 techniques called conventional and statistical. The conventional technique involves the payback period, risk-adjusted discount rate, and certainty-equivalent. The statistical technique involves probability assignment, standard deviation, and coefficient variation. After reading, I was able to see how most of the things we learned in this class go hand in hand, such as the standard deviation, etc.
RESPONSE
You provide a satisfactory start to your discussion, but you never really address the question. You hit on capital budgeting and risk, but you do not explain how capital budgeting incorporates and quantifies risk within its framework for decision making. Hint: Look at the discount rate and/or the weighted average cost of capital…
I look forward to your elaboration on the topic.
DISCUSSION 4
It is evident that uncertainties will exist when an event outcome is not certain especially when trading with assets whose flow of cash are expected to have more than a year of extension, which leads to occurrence of risk element in that scenario (Dayananda, 2002). Therefore the risk evaluation will depend on the ability of the decision maker to clearly identify and appreciate the level of uncertainty that is surrounding the fundamental variables and also having the requirements and the correct methodology for risk implications processing.
The risk in capital budgeting analysis can be quantified through various means. Firstly, sensitivity analysis can be used in state where the entrepreneur analyses project feasibility since the future is uncertain, for example in the case of investments or change of sales value from the anticipated price which can be calculated from net present value (Dayananda, 2002). Nevertheless, risk management method can be used to focus on several factors such as financial leverages, variable and fixed costs, insurance, derivatives, sequential investment and information improvement. Furthermore, break even analysis can be done to allow a firm to regulate the amount of sales and cost of production for a certain project so as to avoid money lose. Corporate risk can as well be used to focus on risk analysis that might influence a whole project in terms of firm’s cash flow (Dayananda, 2002).
Lastly, simulation analysis can be utilized for probability analysis formulation for merit criterion with the aid of variable values random blending to carry out an association with the criterion that is selected.
References
Dayananda, D. (2002). Capital budgeting. Cambridge, UK: Cambridge
RESPONSE
You provide a satisfactory start to your discussion, but you never really address the question. You hit on capital budgeting and risk, but you do not explain how capital budgeting incorporates and quantifies risk within its framework for decision making. Hint: Look at the discount rate and/or the weighted average cost of capital…
I look forward to your elaboration on the topic.
DISCUSSION 5
please let me know if I have answered the question correctly, I want to make sure I did it right.
It is evident that uncertainties will exist when an event outcome is not certain especially when trading with assets whose flow of cash are expected to have more than a year of extension, which leads to occurrence of risk element in that scenario (Dayananda, 2002). The investigation of decision making with capital budgeting put as a consideration would include some techniques that must be employed to give an estimate of the total cost of project risk. The techniques employed can be linked to factors such as capital structure, nature of industry, investment outlay, growth rate etc.
The risk in capital budgeting analysis can be quantified through various means. Firstly, sensitivity analysis can be used in state where the entrepreneur analyses a project feasibility since the future is uncertain, for example in the case of investments or change of sales value from the anticipated price which can be calculated from net present value (Dayananda, 2002). Nevertheless, risk management method can be used to focus on several factors such as financial leverages, variable and fixed costs, insurance, derivatives, sequential investment and information improvement. Furthermore, break even analysis can be done to allow a firm to regulate the amount of sales and cost of production for a certain project so as to avoid money lose. Corporate risk can as well be used to focus on risk analysis that might influence a whole project in terms of firm’s cash flow (Dayananda, 2002).
In conclusion, the risk evaluation will depend on the ability of the decision maker to clearly identify and appreciate the level of uncertainty that is surrounding the fundamental variables and also having the requirements and the correct methodology for risk implications processing.
References List
Dayananda, D. (2002). Capital budgeting. Cambridge, UK: Cambridge
RESPONSE
A firm uses its Weighted Average Cost of Capital or “WACC” to calculate NPV. WACC is the discount rate that the firm uses to determine NPV. It incorporates and quantifies the risk for common stockholders, preferred stockholders and bondholders.
In addition, it is the measurement against which IRR is compared. If a project’s IRR is higher than a firm’s WACC, then it should pursue the project. If the IRR is less than WACC, then the firm should not pursue it.
WACC is a way for a firm to quantify risk.
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