The fourth step is to make a decision based on this best information available and the chosen technique.
The capital budgeting process is fairly straightforward in its structure, but making the determinations is potentially very difficult. There is often significant consideration of what constitutes an incremental cash flow, for example, and the firm must approach this issue with caution. Another tricky part of the process is determining an approach discount rate. The firm must consider its risk, market risk, the risk-free rate and the project's risk. Determining a cost of capital for privately-held firm often means finding a similar publicly-held firm in order to determine what the equity cost of capital might be. The cost of debt is easier to determine -- the bank can tell the firm that.
6. Project risk is incorporated into capital budgeting analysis in the discount rate. The discount rate reflects the rate of return that the firm or the project needs to meet in order for the project to be deemed acceptable relative to its risk. In many cases, the discount rate is the firm's rate. This reflects the fact that...
There are times, however, when the firm will add a project-specific risk premium. This allows the calculation to better reflect the project's risk rather than the firm's risk. The company has the option of how it wants to approach this question.
The other way that project risk is incorporated is with a sensitivity analysis. This technique is conducted by changing some of the cash flows, especially those that are the most sensitive to changes in the environment that are out of the firm's control. The sensitivity analysis shows how the final NPV can be affected by different changes in the cash flow assumptions, or the discount rate assumptions. Thus, the sensitivity analysis provides another method by which the firm can determine the odds of the project's net present value being below zero, and the degree to which different changes affect the NPV as well.
Works Cited:
Investopedia. (2011). Discounted cash flow. Investopedia. Retrieved May 22,…
