Risks and Capital Budgeting Decision

Answer

Risks and Capital Budgeting Decision

Introduction

Capital budgeting decisions that financial managers normally make require an assessment of projects’ future cash flows (FCFs), value of the FCFs, and uncertainty of FCFs. When an organization’s available investment opportunities are looked at, financial managers normally want to gauge which projects will help optimize value for the organization, and by extension, optimize the company’s owner’s wealth (McShane et al., 2011). That is, financial managers analyze all projects that a company has in place, assessing how much each of the company’s projects benefits would surpass their costs. It is based on this analysis that financial managers usually advice their companies to invest in projects/initiatives that are anticipated to raise their companies’ wealth/treasure the most (Kendrick, 2015). Evidently, because of several uncertainties, a company may fail to realize its projected benefits/gains because of risks. According to Lawrence et al. (2013), risk refers to the degree of uncertainty. When financial managers estimate what a given project costs a company to invest in along with its possible gains in the future, they are tolerating uncertainty, which may emerge from various sources dependent upon the kind of investment that the company is considering along with the circumstances as well as the sector in which the company is operating. Bradford (2016) notes that uncertainty may arise due to economic conditions, international conditions, marketplace conditions, interest rates, and, taxes, among other factors. These possible sources of uncertainty have the ability of influencing a company’s FCFs. For this reason, for financial advisors to assess and pick among a company’s various projects that will optimize the company’s wealth the most, there is a need to evaluate the improbability that are connected with a particular project’s cash flows. In assessing a company’s capital project, financial advisors normally have concerns with gauging the project’s risk(s). It is against this premise that this paper aims at describing the types of project risks and detailing the situations in which each type of risk is most relevant when deciding a capital budgeting decision. To comprehensively describe the types of risks, this paper will as well include the effect of correlation between the types of risks, and will also compare and contrast cash counting methodology and accrual accounting methodology with the ultimate goal of illustrating how each of the types of risks work best for diverse kinds of organizations or companies.

Project Risks

According to Lawrence et al. (2013), is we have some knowledge regarding the unpredictability that is associated with a particular project’s FCFs (and the project’s possible results/benefits) along with the likelihoods associated with the outcomes, then we have a measure of the project’s peril. This largely refers to the project’s risk assuming the possible impacts of diversification. Such a kind of risk is referred to as a stand-alone risk (total risk of a project) (Herz, 2016).

Owing to the fact that most organizations or institutions have other assets, the stand-alone type of companies’ other projects under the consideration might unnecessarily be the pertinent risk for assessing the companies’ projects. This is because a company refers to an assortment of various assets. However, the proceeds of these various properties or resources unnecessarily move together; they are not positively perfectly correlated with each other (Mohan & Narwal, 2017). As such, instead of being concerned much about stand-alone risks of a project, there is a need to pay attention to how a company’s project’s assortment of assets vary the danger of the organization’s assortment.

Moving forward, the share of most organizations and institutions may not be possessed by stakeholders who individually hold divergent assortments. According to Lawrence et al. (2013), these investors are usually concerned with how a firm’s investments impact the risk of their individual assortments. When owners claim recompense/compensation for risk(s), they are demanding compensation for marketplace risk(s), the risks that they cannot be able to eliminate or get rid of through diversifying (Lawrence et al., 2013). Acknowledging this fact, an organization that is bearing in mind taking upon a new project ought to take into consideration how the project transforms the marketplace risk(s) of an organization or institution. Thus, if the organization’s or company’s owners hold divers investments, Bradford (2016) states that it is the project’s marketplace risk(s) that is/are relevant to the organization’s/company’s process of making capital budgeting decisions.

While it is the case that we largely hold the belief that it is the project’s marketplace risk(s) that is crucial to assess, stand-alone risk ought not to be assumed. In case a decision is to be made by a small and closely-owned company, who proprietors do not possess well-diversified assortments, the stand-along offers a good idea regarding the project’s risk(s). Worth adding is that most small commercial establishments fit within this category. Batra and Verma (2017) add that even when investment decisions are to be made for large organizations or companies that have a variety of services and products and whose proprietors are well-diversified, the assessment of stand-alone kind of risk is necessary. Adds that stand-alone type of risk is usually closely associated with market risk. According to Drake (n.d), in most cases, projects that have higher stand-alone risk(s) may equally have higher market risk(s). Similarly, a project’s stand-alone risk(s) is much stress-free to measure compared to market risk(s); stand-alone risk of a project can easily be evaluated by assessing the project’s FCFs by use of statistical measures/parameters, sensitivity assessment, as well as simulation assessment (Mohan & Narwal, 2017).

From the above overview, it is evident that there are three distinct project risk types. Firstly is the stand-alone risk. Stand-alone risk refers to the total risk of a project if the project were independently operated or run (McShane et al., 2011).Drake (n.d) notes that stand-alone risk assumes both a company’s projects’ diversification as well as investors’ diversification among companies. This project risk type is gauged/measured either by the standard deviation of a project’s Net present value (NPV) or the project’s coefficient of NPV (Mohan & Narwal, 2017). Worth adding is that other profitability parameters, like modified internal rate of return (MIRR) and Internal Rate of Return (IRR), can equally be employed in obtaining a project’s stand-alone risk approximates.

Secondly is the market risk. According to Böcker (2010), market risk refers to the audaciousness of a project to some well-diversified investor(s). For this reason, the market risk of a project takes into consideration the diversification that is intrinsic in companies’ portfolios of stockholders (Batra & Verma, 2017). This kind of project risk type is measured by gauging the marketplace beta of a particular project, which is basically the slope of regression line that is formed by plotting a project’s proceeds against its proceeds upon the marketplace under consideration (Boubaker et al., 2016).

Thirdly is the within-firm risk (corporate risk). This kind of risk connotes the total precariousness of a project, paying attention to a company’s other projects; giving consideration to the diversification in a company (McShane et al., 2011). Basically, the within-firm risk the contribution of a project to a company’s total risk. Within-firm risk is a function of: (1) the correlation of the proceeds of a project with the returns of a firm’s other projects and (2) a project’s NPV’s standard deviation (Herz, 2016). Corporate risk is gauged using the corporate beta of a project, which refers to the gradient of the line of regression that is formed by plotting a project’s proceeds against the project’s proceeds upon the firm (Böcker, 2010). Evidently, there is a correlation that exists between these three types of project risks. Since most projects that are undertaken by companies and organizations are in the organization’s core business, Fields (2016) states that stand-alone risk have a high likelihood of being correlated with a firm’s corporate risk. Similarly, a company’s corporate risk have high likelihood of being correlated with the firm’s project’s market risk.

Each of the above type of project risk can be used in a company’s capital budgeting processing. Owing to the fact that organizations’ fundamental objective is to make the most of their organizations’ shareholders’ treasure, the most pertinent risk for a company’s capital projects is market risk (Boubaker et al., 2016). Nevertheless, suppliers, customers, creditors, and workers are often affected by a company’s total risk (Griffin & BarCharts, 2017). McShane et al. (2011) reason that since customers, suppliers, creditors, and employee significantly role play in influencing a company’s profitability within-firm risk of a company’s project ought not to be entirely ignored or assumed. Regrettably, by far one of the simplest and easiest project risk to gauge is the stand-alone risk of a project. For this reason, companies usually concentrate on the stand-alone risk when deciding regarding capital budget. Nonetheless, this focus does not unavoidably lead to poor decisions since most projects that are undertaken by organizations are in the core of the organizations’ projects. In this case, stand-alone risk of a project has a high probability of being correlated with a project’s within-firm risk, which subsequently has high likelihood of being related to a project’s market risk (Herz, 2016).

Studies have shown that market risk of a project is hypothetically best in a number of situations. Nonetheless, customers, creditors, suppliers, and workers are extra impacted by corporate risk. For this reason, corporate risk of a project is equally pertinent. The correlation evident between these types of project risk is crucial since all project risk evaluations can gauge or measure to help come up with good ideas for decision making (Fields, 2016). Hopkinson (2011) argues that stand-alone risk of a project is easiest and simplest to measure and is extra intuitive.  Core projects, as noted by Griffin and BarCharts (2017), are greatly interrelated with other assets of a company, implying that stand-alone risk of a project largely replicates corporate risk of a project. Goel (2016) reasons that in case a project is extremely interrelated with the economy, then stand-alone risk of an organization’s project equally reflects the company’s project’s market risk.

Cash Accounting vs Accrual Accounting Methodologies

To demonstrate how the above project risk types individually work best in different organizations or companies, there is need to understand accounting and accrual accounting methodologies accounting. Of the two accounting methods, a small company has to choose which method to employ depending upon the company’s legal commercial business, the company’s sales volume (Kendrick, 2015), whether it extends credit to a company’s customers or keeps an inventory (Sandeep, 2016), as well as the tax requirements that are set forth by the company’s Internal Revenue Service (IRS) (Herz, 2016). 

The cash-basis accounting method is an accounting method that recognizes expenses and income in accordance with real time cash flow (Goel, 2016). In this accounting method, income is recoded on receipt of money/funds, as opposed to when was is really received; expenses are equally chronicled as they get paid, as opposed to when they are really incurred (Dobson et al., 2012). Therefore, under this accounting methodology, there is an opportunity of deferring taxable income by carrying to a later date billing with the ultimate goal of ensuring that payment is not received within the present year. Additionally, there is an opportunity of fast-tracking expenses by paying the expenses instantaneously the bills are accrued, or prior to the due date. Conversely, a firm making use of an accrual basis methodology for its accounting methods acknowledges both expenses as well as income at the time when they are incurred or earned, notwithstanding when cash linked to those dealings changes possessions. Under the accrual basis, revenue of an organization is recorded when they are earned as opposed to when they are received; expenses of a company are recorded when they are incurred as opposed to when payment is made.

Worth adding is that under the accrual basis accounting method, revenues or proceeds are noted down immediately they happen as opposed to when payment is received and expenses are documented immediately they are incurred as opposed to when payments are made. Generally, the accrual basis is the most employed by many companies and businesses simply because this accounting form reflects a better monetary picture of what a firm is actually valued at by acknowledging expense and income notwithstanding of whether cash has been paid out or received.

Undeniably, there are several differences and similarities between accrual basis and cash-basis accounting methodologies. One of the main differences between the accounting methods touches on timing. Cash-basis methodology records revenues when cash is received as opposed to a moment before (Mohan & Narwal, 2017). The methodology also only acknowledges an expense when cash has actually been paid out (Hopkinson, 2011), implying that if a bill is resting on an individual, if the same is not paid then it is regarded as expense in this accounting methodology till that point a check is written to pay the bill (Kendrick, 2015). Conversely, in accrual basis methodology, revenue is recognized when it is earned as opposed to when it is received and expenses are acknowledged when bills are received notwithstanding when they are paid (Kendrick, 2015). Another difference regards how cash is tracked. Within the cash-basis methodology, records of cash outflows and inflows are recorded immediately they occur. Nonetheless, the methodology does a terrible job of matching expenses and revenues within a company’s accounting period that they happen (Dobson et al., 2012). Conversely, accrual basis accounting methodology does a great job of matching expenses and revenues and a horrible job of tracing cash outflows and inflows since the system acknowledges income before they are actually received as well as expenses before they are paid. 

Griffin and BarCharts (2017) add that the cash basis accounting methodology has a number of advantages: (1) it is easy and simpler compared to the accrual methodology; (2) it offers an extra accurate and correct picture of a company’s cash flow; (3) as well as the fact that income in this case is not subject to taxation till the money is really received. One main limitation of cash-basis methodology is that revenues and expenses are unmatched in good time. Conversely, the accrual methodology of accounting is designed in a way that it acknowledges expenses and revenues within the period to which they rightly apply, notwithstanding whether money changes hands or not (Lawrence et al., 2013). Consequently, the firm employing an accrual methodology will have records that display a company’s expenses as well as for a company’s project within the same period.  As such, the main strength of accrual basis accounting methodology is that it gives an extra accurate depiction of a how a company is doing over a long period of time relative to the cash basis method (Bradford, 2016). Nonetheless, the methodology has the weakness that it is extra intricate compared to the cash basis methodology alongside the fact that income taxes might be billed upon proceeds before actual payment is gotten.  

For a company to avoid the above discussed project risk, Sandeep (2016) argues that under generally agreed principles of accounting, the accrual-basis type of accounting is needed for all organizations/companies/businesses handling inventory, that is from small retailing businesses to large manufacturing business establishments. Mohan and Narwal (2017) add that it is generally required that before a company makes capital budgeting decisions, they should have gross sales of above $5 million yearly, despite exemptions for farming companies/organizations as well as qualified individual service corporations, like lawyers, consultants, accountants. Batra and Verma (2017) argue that a business that decides to employ the accrual basis accounting methodology must consistently employ it for all its monetary recording as well as for credit purposes. For some running more than one business, it is recommended that they use various accounting methodologies for each business.

Conclusion

To sum it up, there are various project risk types that companies encounter when a company has to make decisions regarding capital budgeting. They include: stand-alone risk, within-firm risk, and market risk. Despite the fact that these types of project risk are different, this study has shown that they are correlated. Similarly, it has been revealed that each risk kind is most pertinent when making a capital budgeting decision in various kinds of companies. This is supported by an analysis of the accrual basis and cash basis accounting methodologies.  From the above explanation, it is clear that in some situations or cases, business or companies find it appealing to change from a given accounting methodology to another to avoid project risk that may accrue to them as a result of using a given methodology. Nonetheless, it is worth noting that changing accounting methodologies when making capital budgeting decisions needs formal authorization of the IRS. Changes in accounting methodologies largely result in modifications of a company’s taxable income, either negative or positive.