Capital budgeting refers to the process businesses use in deciding what long-term investments to pursue or reject. In general, capital budgeting projects are marked by the large size of the total investment and a lead time of more than a year before the business can expect a return on investment. Although all long-term investments carry some risk, a number of factors increase the riskiness of a capital budgeting project.
The project itself or the associated activities of employees in pursuing the project can increase the riskiness of a capital budgeting project. Management may not accurately predict cash flows for the project. It may also become apparent that the project, while viable, cannot meet its original schedule or that it requires different, more expensive material resources than anticipated. Businesses can manage some of this risk by undertaking several, similar projects. A set of similar projects banks on the idea of most projects yielding predictable performance and limits the damage from the failure of one project failure.
Abrupt changes to industry-specific regulations, such as changes prompted by an industrial accident or disaster, increases the risks of capital budgeting projects. Regulatory changes can increase costs associated with safety management or widely used processes. Scientific advancement or technological breakthroughs can also increase risks. If, for example, you invest in new equipment and someone develops new machinery that does the same work but costs half as much to purchase or run, you end up at a strategic and financial disadvantage.
Unforeseen activities on the part of competitors can increase risk. If a competitor invents a new process that cuts production costs, it can undermine all of your projections in regard to your project. On the flip side, if a competitor goes out of business with no warning, it can radically increase demand on your business. If your capital budgeting project aims at increasing your production capacity by 50 percent over the next year, but demand increases 200 percent, you may find it impossible to meet the demand. Although, by nature, competition risk arises from uncertainty regarding competitors’ exact plans and financial status, periodic competitor assessments can help you prepare contingencies based on competitor weaknesses.
Market risk refers to a broad range of sub-factors that can increase the riskiness of capital budgeting projects. Changes in interest rates, inflation and stability or instability of economic growth all impact the risks. The level of risk aversion investors experience at any given time can also make projects riskier, as high-risk projects receive far less favorable terms from investors during periods of economic uncertainty.