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Techniques of Capital Budgeting under Certainty Conditions
Investors use a capital budget when selecting their investments. A capital budget is a plan for investing in long-term assets such as buildings and machinery. Risk is inevitable to these investments. The various risks include cash flows not being paid in time as agreed, the risk of the investee company collapsing and also the management sinking the invested funds in risky projects.
By incorporating risk in capital budgeting, investors can minimize losses. Investors try to avoid risk. To encourage investors to invest their funds into risky projects, the returns from such projects should be higher than returns from less risky investments such as treasury bonds.
A risk premium is a discount rate that is added to the risk-free rate of borrowing. The risk-free rate is the rate of return of low-risk investments such as government-backed securities. The investments are then appraised using the resulting discount rate. Investments that offer better returns are chosen.
by R.L. CRUM
The time it takes for a project to pay back the amount of money invested is a matter of concern to the investor. Investors set a time limit within which they expect to receive returns.
Each project's cash flow is determined. A project whose return falls beyond the time limit will deemed to be risky. While appraising projects, future cash flows are estimated using probability measures like forecasting techniques. These measures do not give a true picture of future events.
To avoid uncertainty, convert expected future cash flows into certain cash flows.
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