Capital Budgeting essay
Capital budgeting comprises an integral part of the effective business development because companies have to focus on the most prospective and profitable projects with the balanced risk-returns ratio. Capital budgeting is the process, which determines whether the particular project is worth pursuing. Investing too much into capital budgeting leads to the narrow development of the company with the focus on a few secure and profitable projects, while others projects may remain under-estimated and the company can fail to invest into a risky but potentially successful project. Investing too little into capital budgeting can raise the problem of the low effectiveness of company’s investments, if the company fail to determine priority projects which are the most prospective and beneficial for its further business development.
Sunk costs are costs that cannot be changed and are irrelevant to the decision making process because they are the past costs that have been already spent but currently the equipment, machinery or other items purchased are virtually useless. Opportunity costs are costs involving the alternative chosen that has brought profits to the company. In contrast to sunk costs, which brought financial losses to the company, opportunity costs bring profits. However, both opportunity and sunk costs have ceased their impact and cannot be used anymore.
Capital budgeting is associated with three types of risks, including stand-alone risk, corporate risk, and market risk. Stand-alone risk is the risk associated with a particular project and means that the company faces a high risk of the failure of completing the particular project successfully. The corporate risk implies that the entire company is at risk and its business operations are under a threat. Therefore, the company may face a risk of losing its marketing position or even run bankrupt. As for the market risk, this is the risk associated with the possible downturn or crisis within the market, as was the case of the housing market in the US in 2007-2008. Each type of risk is necessary to assess and control because the failure to identify either risk may lead to the failure of the project.
The qualitative risk focuses on the assessment of actual risks associated with a particular project or company. However, the qualitative risk is subjective because it relies on the assessment of qualitative attributes and does not involve quantitative ones. Nevertheless, this risk is essential to assess to understand prospects and risks associated with a particular project to the full extent. The qualitative risk focuses on the assessment of the particular project and related risks from the qualitative standpoint that means that the assessment involves the analysis of the qualitative information related to the project and associated risks. As a result, the company conducting the assessment of the qualitative risk can determine whether the project is worth implementing or not. For example, the introduction of a new product is accompanied by the qualitative risk assessment. The company monitors the customer behavior and conducts interviews of a group of customers to assess the qualitative risk. On the ground of their responses, the company makes conclusion concerning the risk. Obviously, such risk assessment is subjective because it is grounded on subjective responses of customers. Nevertheless, such risk assessment helps to understand better real world prospects of a particular project.
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