Abstract
In determining the feasibility of projects where capital investments are concerned, various methods are used. The focus of these methods is on return per se, so it is often asked to what extent any of these methods take the risk concept into account. The main objective of this study was to investigate the importance of risk with regard to capital investment projects. Secondly, with the aid of an empirical study, the study tried to establish whether risk is incorporated when South African companies evaluate capital investment projects. The empirical analysis indicated that risk analysis and evaluation in practice are to a large extent neglected by South African companies. It was found that nearly a quarter of companies estimate their annual cash flows using management subjective estimates alone.
Highlights
The evaluation of capital investment projects can be regarded as one of the most important tasks of any financial manager
The primary purpose of sensitivity analysis is not to quantify risk, but to establish how sensitive the Net Present Value (NPV) and the Internal Rate of Return (IRR) are to changes in the values of key variables in the evaluation of investment projects
The risks per se are not quantified, sensitivity analysis offers companies a relatively easy and cost-effective method to adjust for return related risks associated with capital investment decisions as they can assess influences on key outputs of the investment process and assist with decision making
Summary
The evaluation of capital investment projects can be regarded as one of the most important tasks of any financial manager. The substance of capital investment evaluation methods is return per se, but it is often asked to what extent any of these methods takes risk into account. The discount rate is derived from a weighted average cost of capital (WACC), which refers to the required rate of return in a specific company. This is not incorrect, one should realize that the WACC of a particular project may be quite different from that of the company evaluating the project, resulting in either a higher or lower required rate of return being used in the evaluation process
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