Six Basic Capital Budgeting Questions Essay

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Finance

One of the biggest differences between new capital projects and renewal/replacement projects is that the variables are less known. The cash flow for the next few years is subject to a higher degree of uncertainty, but so too is the risk profile for the project. The latter is especially important when the project is in an entirely new business, and the firm has very little concrete information to go on. The reality is that for renewal projects, there is a lot more certainty about everything, and that makes a difference in the capital budgeting process because the numbers are more reliable and the company knows that the discount rate appropriately reflects the risk associated with that project. It must be cautioned, however, to remember that incremental cash flows only should be incorporated into the calculation for renewal projects, not money that has already been committed to the project (Investopedia, 2016).

Interest charges are not included in the cash flows for the project because interest represents a financing charge. Financing charges are reflected in the discount rate, which includes the cost of capital, which itself includes the cost of debt. Because of the Modigliani-Miller principle, financing charges are not included as cash flows as the type of financing should ultimately not matter (Investopedia, 2016).

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3 There are several different types of risk that affect operations of corporations. There is strategic risk, which relates to operating in that industry at that moment in time. An example would be whatever risk was inherent in making PDAs when the smartphone was invented and killed the category. There is also firm-specific risk that relates more to the company than the industry, such as the reality that firms with one product face greater risk than firms that have a more diversified portfolio. There are legal risks relating to any number of laws, and political risks that relate to the influence of government and government action over business. Political risk can vary dramatically across different countries (Griffin, 2016).

There are different financial risks, including credit risk (related to extending credit to customers), foreign exchange rate risk (when dealing in other currencies) and interest rate risk. There might be reputation risk, especially for companies that are just starting to build their brand. The value of that brand is sometimes at risk if the company has a problem with a key product, or if the company itself faces….....

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