The Relationship between Risk and Capital Budgeting

Investment appraisal or capital budgeting involves the evaluation of investment options during financial planning to determine the viability of each option. Capital budgeting and investment decisions are often associated with significant risks. When choosing a project to invest in, the company must consider all costs and risks involved with each choice. Risk can be defined as the possibility of an undesired outcome. In relation to investment, a risk is the possibility that the investment activity may lead to a loss or an undesired outcome. Some of the risks associated with investment projects together with the measures used to mitigate them are described below:

  • Operational Risks: This type of risks includes all the internal and/or external conditions that affect the daily operations of business. Some of the operational risks that a business may encounter include natural disasters, bad weather conditions, damage to premises and equipment, delays in materials, and errors in payments. These risks can be mitigated by developing business continuity plans or contingency plans, which provide steps to be taken to minimize disruptions or reduce their impacts on business operations.
  • Financial Risks: Also known as economic risks, this type of economic risks refer to the likelihood that an event may occur, leading to financial losses or reduced profits. Financial risks may be caused by fluctuations in exchange rates, price fluctuations, and market movements. Financial or economic risks can be mitigated by easing cash flows using appropriate cash management systems. Some organizations and individuals may also use insurance, diversifications, and reduced loans to mitigate financial risks.
  • Security Risks: Some risks are related to security issues such as data breach, privacy violations, identify theft, fraud, money laundering, and intellectual property theft. These types of risks pose security problems to individuals and organization. Lack of security features in an online payment system may expose users’ data, which can be used to defraud unsuspected customers.
  • Compliance/Legal Risks: the legal environment is constantly evolving as new laws and regulations are formulated to government business operations and contracts. A company should understand the legal frameworks under which their businesses operate to avoid litigation and legal liabilities. To mitigate compliance risks, the company should have a legal team that constantly assesses the legal environment to identify new laws and develop policies that are necessary to meet those laws.
  • Reputational Risks: These risks include situations that can damage the company’s reputation or public image. For example, faulty products, poor customer support and negative publicity may lead to bad reputation for a business. To mitigate reputational risks, a company should develop a public relations team that communicates with the public to influence public opinion about the company positively.

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