How Investment Risks and NPV affect Capital Budgeting Analysis and Decision Making

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1 How Investment Risks and NPV affect Capital Budgeting Analysis and Decision Making Solange Sanchez Corporate Finance – 11107 Dr. Wayne Morgan 2/11/2024 Capital Budgeting is an analysis run by businesses to help determine which fixed assets purchases to make and/or accept. The analysis is crucial in instances where there are not enough

2 funds in a company to pay for every project that is being proposed. Oftentimes, lenders might require this analysis if they are being asked for a loan to fund a project. The process of the analysis is to review cash inflows and outflows to get a better understanding of potential expected return on the investment and making a decision based on these projections. The type of project and amount of investment also affects how detailed the analysis has to be in the capital budgeting process. For example, low-risk investments would be okay with an analysis that is not overly detailed. However, high risk and high-volume investments would need a longer and more detailed analysis in order to get a full understanding of the potential risks a project may have and then decide whether to accept these risks and move forward with the project. Remember that low risk typically refers to short-term projects while high risk usually involves projects that will take a longer time to complete. This is because the longer the term the more likely circumstances could change and affect the project and so the risk involved is higher. To put it simply, the level of risk reflects the level and detail needed for the Capital budgeting analysis. Now to dive into capital budgeting in more detail, let’s analyze the decisions around when two mutually exclusive projects are being compared and how to decide which project to take one. In the capital budgeting world, a short-term project would be perceived as higher under the NPV criterion if the cost of capital is high, whereas a long term project might be seen as the better option of the two if the capital is low. This is because when the cost of capital is high, projects that have a short lifespan will tend to generate a higher Net Present Value because of the discounting effect. This is primarily due to the fact that cash flows for these projects are received much sooner which reduces the impact of discounting. On the other hand, projects that have a longer term will have a higher NPV when the cost of capital is low because the discounting effect is not as prominent. Additionally, since neither an increase or decrease in the cost of capital affect the internal rate of return, it would

3 not change the raking for either of the above mentioned projects. It would, however, add to the decision of which project would be a better option but the IRR would not be affected. References:

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4 Ganti, A. (2023, June 12). Internal Rate of Return (IRR) Rule: Definition and Example . Investopedia. Retrieved February 11, 2024, from https://www.investopedia.com/terms/i/internal-rate-of-return-rule.asp Hofstrand, D. (2023, June 1). Capital Budgeting Basics . Iowa State University Extension and Outreach. Retrieved February 11, 2024, from https://www.extension.iastate.edu/agdm/wholefarm/html/c5-240.html#:~:text=There %20are%20several%20capital%20budgeting,Modi%EF%AC%81ed%20Internal%20Rate %20of%20Return . Vipond, T. (n.d.). Internal Rate of Return (IRR) . Corporate Finance Institute. Retrieved February 11, 2024, from https://corporatefinanceinstitute.com/resources/valuation/internal-rate- return-irr/

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