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RISK ANALYSIS IN CAPITAL BUDGETING

 

CHAPTER ONE

INTRODUCTION

1. BACKGROUND OF THE STUDY

 

Capital budgeting involves the entire process of planning expenditures whose returns are expected to extend beyond year, when business enterprise makes a capital investment, it incurs a current cash outlay for benefits to be realized in the future, the firm’s decisions to invest funds in the long term assets are of considerable significance since the intend to influence the firm’s wealth determine of size, affect its business risks as well as see the pace and direction of the firm’s growth, in this light, capital budgeting decision may be defined as the firm’s decision to invest its current funds most efficiently in long term activities in anticipation of an expected flow of future benefits over series of years.

 

1. STATEMENT OF THE PROBLEM

 

According to the Ho and Pike (1991) describe why the challenge of handling risk and uncertainty is one of the most prominent problem in capital budgeting practice, they describe the uncertainty of risk due to the underlying economic environment and its instabilities and inflation levels.

In practice, executives can handle risk in two days, the simple risk adjustment method is based on the execution’s estimations and in future adjustments to cash flows, the probabilistic risk analysis (PRA) is based on evaluation of the uncertainties associated with particular variables before decisions are made.

 

1. THE PURPOSE AND OBJECTIVES OF THE STUDY

 

The sums involved are relatively large so that bad decisions may have very serious consequences

• The time scale over which the benefit will be recovered its reliability long this has the consequence of making a business to live with any mistakes for a considerable length of time
• The whole nature of a business and its direction as well as rate of progress is ultimately governed by its overall investment programme
• Capital investment involves waiting for the recouping of expenditure, because money can be used to earn interest, waiting has a cost
• Capital budgeting are very difficult to make, the decision require an assessment of future events which are uncertain it is really a complex problem estimate the future benefits and costs correctly in a quantitative terms.

 

1. SIGNIFICANCE OF THE STUDY

 

The importance of this research work will rest squarely on the fact that through if, decision on whether to invest or not to invest the organization’s, or to analysis the risk in capital budgeting an efficient working capital management will be put to rest, but differently outcome of this work will

• Either criticize the risk analysis in capital budgeting
• The study will provide a useful piece of information on capital budgeting
• It will support the firm and organization on how to invest and the risk involve in capital budgeting
• It will equally serve as a stepping instance to further research work.

 

1. RESEARCH QUESTIONS

 

In the course of carting out the research the following research questions were formulated;

1. What is the risk involve in capital budgeting in Nigeria
2. What are the implications in risk analysis in capital budgeting
3. Has firms, organization benefited from the existing system of capital budgeting
4. Is there need to appraise the technique of risk analysis in capital budgeting
5. How can the problem of working capital budgeting be identified.

 

1. HYPOTHESIS OF THE STUDY

 

The hypothesis formulated for are purpose of the study are:

        To enable the researcher to carryout proper analysis of the information obtained form respondents the following hypothesis were formulated.

Hypothesis No. 1

Null Hypothesis

Ho:   Risk analysis in capital budgeting by the organization has not been effective

Hi:    Risk analysis in capital budgeting in the organization has been effective.

Hypothesis No. 2

Ho:   Risk analysis in capital budgeting have not benefited much from the public

Hi:    Public organizations have benefited much from the use of risk analysis in capital budget.

 

1. SCOPE OF THE STUDY

 

The study will dwell on the structure and capital budgeting.

1. Risk
2. Liquidity risk
3. Interest rate risk
4. Project specific risk
5. Industry specific risk
6. Competitive risk
7. Corporate risk analysis
8. Industry specific risk.

 

1. SCOPE, LIMITATION AND DELIMITATION OF THE STUDY

 

Its approach to reduction of cashflow forecast is implicit and may be inconsistent from one investment to another

• A forecaster who expects a reduction in his forecasts may inflate them in anticipation this will no longer give forecast according to the best estimates
• If forecast have to past through several layer of management the original forecast may be greatly adjusted
• It is not simple to compute
• It can be hardly to understood.

 

1. DEFINITION OF TERMS

 

1.     Capital Budgeting: Is a process of identifying and selecting investment to determine a firm’s expenditures on assets whose cash flows are expected to extend beyond one year.

2.     Scenario Analysis: Is as method of assembling probable future occurrences by taking into account alternate probable consequences or scenarios.

3.     Certainty Equivalent Approach: The certainty approach to risk analysis is to convert cash flows from individual projects into adjusted certainty equivalent cash flows.

4.     Risk Analysis: The process of measuring and analyzing the risk associated with managerial and investment decisions.

5.     Business Risk: The risk associated with changes in a firm’s sales, this may be due to operating difficulties such as strike and technological obsolescence.

6.     Market Risk: The changes in the price of a portfolio of investment arising from changes overall stock market irrespective of the fundamental financial condition of the company.