The Incorporation of Risk in the Capital Budgeting Decision

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. Smaller companies tend not to use any formal risk technique. Many South African companies do not make adjustments for the inflation rate when they assess the viability of a capital investment project. Although the majority of companies use various inflation rates for different annual cash flows, it was found that nearly a quarter of companies do not make adjustments for inflation.