Capital Budgeting and Project Risk
Project risk
Capital budgeting under risk tests sensitivity, scenario, simulation, risk-adjusted discount rates, certainty equivalents, decision trees and real options.
Core rules
- Sensitivity asks how far one variable can move before NPV reaches zero.
- Scenario analysis changes several variables together; simulation assigns probability distributions.
- Risk-adjusted discount rates add a premium for systematic risk; certainty equivalents convert risky cash flows into risk-free equivalents.
- Do not double-count risk by adjusting both cash flows and the discount rate.
- Real options include the option to delay, expand, abandon or switch, and can add value beyond static NPV.
Worked example
Using the machine above, NPV is LKR 26,800 and the annuity factor is 3.170. The annual inflow can fall by 26,800/3.170 = LKR 8,455 before NPV is zero, a sensitivity of 8,455/40,000 = 21.1%. A 21% fall in selling price or volume would eliminate the project's value. If the project can be abandoned for LKR 60,000 after one year, that option reduces downside risk and should be valued separately; ignoring it understates NPV.
Traps
Do not call sensitivity a probability; do not add a risk premium to a project whose cash flows have already been certainty-equivalent adjusted; do not ignore managerial flexibility; and do not use a single-point NPV as a complete decision rule.