Risks in Capital Budgeting are from five different sources. They are:
Project-specific risk could be traced to something quite specific to the project. Managerial deficiencies or error in estimation of cash flows or discount rate may lead to a situation of actual cash flows realised being less than the projected cash flow.
Competitive or competition risk
Unanticipated actions of a firm’s competitors will materially affect the cash flows expected from a project. As a result of this, the actual cash flows from a project will be less than that of the forecast.
Industry-specific risks are those that affect all the firms in the particular industry. Industry-specific risk could be again grouped into technological risk, commodity risk and legal risk. Let us discuss the groups in industry specific risks, as follows:
- Technical risk
- Commodity risk
- Legal risk
These types of risks are faced by firms whose business consists mainly of exports or those who procure their main raw material from international markets.
The firms facing such kind of risks are as follows:
- The rupee-dollar crisis affected the software and BPOs, because it drastically reduced their profitability.
- Another example is that of the textile units in Tirupur in Tamil Nadu, which exports the major part of the garments produced. Strengthening of rupee and weakening of dollar, reduced their competitiveness in the global markets.
- The surging crude oil prices coupled with the governments delay in taking decision on pricing of petro products eroded the profitability of oil marketing companies in public sector like Hindustan Petroleum Corporation Limited.
- Another example is the impact of US sub-prime crisis on certain segments of Indian economy. The changes in international political scenario also affected the operations of certain firms
Factors like inflation, changes in interest rates, and changing general economic conditions affect all firms and all industries. Firms cannot diversify this risk in the normal course of business.
There are many techniques of incorporation of risk perceived in the evaluation of capital budgeting proposals. They differ in their approach and methodology as far as incorporation of risk in the evaluation process is concerned.