The strategies to diversify the risk in the projects are very varied and form a fundamental part to increase the yield at a given level of risk.
Cash flows related to capital budgeting projects are future cash flows, which is why an understanding of risk is of great importance in making appropriate decisions about capital budgeting.
Most capital budgeting studies focus on the problems of risk calculation, analysis and interpretation, this article aims to explain the fundamental techniques used to assess risk in capital budgeting, among the most used are the subjective system, expected value system, statistical systems, simulation and risk-adjusted discount rates, which are presented in detail below.
Variability
The terms risk and uncertainty are often used interchangeably to refer to the variability of the project's cash flows.
Subjective system
The subjective system for risk adjustment involves the calculation of the net present value of a project to immediately make the capital budgeting decision based on the subjective evaluation of the decision maker about the risk of the project through the calculated return.
Projects that have similar net present values but are believed to have different degrees of risk can be easily selected, while projects that exhibit different net present values are much more difficult to select.
The use of fluctuation techniques such as optimistic, highly probable, and pessimistic estimates of project returns is also somewhat subjective, but these techniques allow the decision maker to make a slightly more disciplined guess with reference to comparative risk. of the proyects.
System of expected values
This system involves the use of estimates of different possible outcomes and the combined probabilities that these occur to obtain the expected value of return. This kind of system is sometimes called " Decision Tree Analysis " because of the branch-like effect of graphing these kinds of decisions.
This system does not directly address the variability of the project's cash flows, but uses what can be considered risk-adjusted cash flows to determine the net present values that are used to make the decision.
The expected value system is an improvement over purely subjective systems, although it also has some degree of subjectivity.
Statistical systems
Techniques for measuring project risk using standard deviation and coefficient of variation. In this a study of the correlation between projects is carried out. This correlation when combined with other statistical indices, such as the standard deviation and the expected value of the returns, provides a framework within which the decision maker can make risk-return alternatives related to different projects to select those that are best suited. towards your needs.
In general terms, the further into the future the cash flows to be received, the greater the variability of these flows.
Highly sophisticated statistical techniques have been combined into a body of knowledge called " Portfolio Theory ", which offers techniques for selecting the best among a group of available projects taking into account the risk-return propensity or profit function. of the company.
These systems are not subjective, since they consider the expected values, standard deviations and the correlations between projects to select those that best fulfill the objectives of the administration.
Simulation
Simulation is a sophisticated system with statistical bases to deal with uncertainty. Its application to capital budgeting requires the generation of cash flows using predetermined probability distributions and random numbers. By putting together different components of cash flow in a mathematical model and repeating the process many times, a probability distribution of project returns can be established.
The procedure of generating random numbers and using probability distributions for cash inflows and outlays allows the values for each of these variables to be determined. Substituting these values in the mathematical model results in a net present value. By repeating this procedure, a probability distribution of net present values is created.
The key to successfully simulating the performance distribution is to identify exactly the probability distributions for the variables that are added and to formulate a mathematical model that actually reflects the existing relationships.
By simulating the different cash flows related to a project and then calculating the NPV or IRR based on these simulated cash flows, a probability distribution of the returns of each project can be established based on the NPV or the IRR criterion..
With this type of system, the decision-maker can determine not only the expected value of the given or improved performance. The performance of the simulations provides an excellent basis for making decisions, as the decision maker can consider a continuum of risk-return alternatives rather than a single point of estimation.
Risk-adjusted discount rates
Another way to treat risk is to use a risk-adjusted discount rate, k, to discount the project's cash flows. To properly adjust the discount rate, a function is necessary that relates risk and returns to the discount rate.
Such a risk-return function or market indifference curve, in this case the risk is calculated by means of the coefficient of variation. The market indifference curve indicates that the cash flows associated with a risk-free event are discounted at an interest rate. Consequently this represents the rate of return without risk.
When they are discounted at a certain risk rate, this must be calculated as close as possible to business reality, since if a company discounts cash flows with risk at too low a rate and accepts a project, the price of the company may decline and therefore more dangerous for investors.
