Capital Budgeting may be defined as the decision making the process by which a firm evaluates the purchase of major fixed assets including – building, machinery and equipment. It is a step by step process that businesses use to determine the merits of an investment project. It is a company’s formal procedure used for evaluating possible expenditures or investments that are important in amount.
Methods of Incorporating project risk into capital budgeting decisions: There are two methods are used for incorporating project risk into the capital budgeting decision process.
(1) Certainty equivalent method: It is the first method, in which the expected cash flows are adjusted to reflect project risk – risky cash flows are scaled down, and the riskier the flows, the lower their certainty equivalent values. It is a method in which uncertain cash flows are converted into certain cash flows by multiplying with a probability of occurrence such as cash flows. It is the risk-free cash flow which an investor considers equivalent to a higher but risky expected cash flow.
(2) Risk-adjusted discount rate method: It is the second procedure or method, in which differential project risk is dealt with by changing the discount rate average-risk projects are discounted at the firm’s corporate cost of capital, above-average-risk projects are, discounted at a higher cost of capital, and below-average-risk projects are discounted at a rate below the corporate cost of capital. Risk-adjusted discount rate is representing required periodical returns by investors for pulling funds to the specific property. The concept reflects the relationship between risk and return.