Introduction
Organizations face risks and uncertainties in their daily operations. Consequently, it is important to distinguish between risks and uncertainties. In the field of finance, risk and uncertainty are two closely related terms, but they are not interchangeable. Risk in finance refers to a situation where the outcome of a potential decision can be measured or estimated with a reasonable degree of accuracy (Brown, 2020).
On the other hand, uncertainty refers to a situation where the outcome of a particular decision cannot be measured or estimated with any degree of accuracy (Szpiro, 2020). In essence, the risk is quantifiable and can be expressed in terms of probabilities, while uncertainty is non-quantifiable since it includes unknown factors. Understanding the difference between risk and uncertainty is critical when making capital budgeting decisions.
Traditional and Contemporary Methods for Risk Assessment in Capital Projects
Traditional Approach
Advantages
The traditional and modern approaches to dealing with risks are utilized when appraising capital projects. The traditional approach involves using several methods, such as the net present value (NPV) and internal rate of return (IRR), among others, to estimate the return on investment and risks associated with a particular capital project (Malenko, 2018).
The traditional method assumes that the future cash flow of a project can be estimated with a higher degree of accuracy based on past performance and other relevant data (Senthilnathan, 2020). One of the strengths of this method is that it is relatively easy and clear (Farrar, 2020). In addition, it provides clear measures of risks and returns associated with a certain project. This method is also widely applied in multiple incidences and has been proven to be effective.
Disadvantages
Despite the positives highlighted above, the traditional approach has several weaknesses. One of these weaknesses is that it is highly reliant on past data to predict the future. Past data may not always be valid, accurate, or reliable. In such a case, estimates of returns and risks may be inaccurate, leading to a loss of money, especially if uncertainties are greater (Miller, 2022).
Secondly, the traditional method assumes that risk can be quantified and measured straightforwardly (Michelon, Lunkes, Bornia., 2020). In practice, risks cannot be quantified and measured in a straightforward manner since they are complex and interdependent, making such an approach unrealistic.
Modern Approach
Advantages
The modern approach is an improvement of the traditional approach and considers the uncertainties involved in a particular project when making capital-budgeting decisions. The modern approach recognizes that capital projects are not a one-time irreversible investment but a series of decisions that can be adjusted based on changing markets and new information (Abernathy et al., 2019).
One of the strengths of this model is greater flexibility and adaptability. In addition, this method provides a more accurate assessment of risks and returns associated with a particular project (Mubashar& Tariq, 2019). This approach also considers the value of information, which is critical to improving decision-making in an uncertain environment.
Disadvantages
However, this approach is complex and difficult to implement, especially when a project has multiple decision points that are characterized by uncertainty (Kengatharan, 2018). This approach also requires a more-than-average understanding of financial theory and options pricing, which are complex concepts that some investors may fail to grasp (Turner &Coote, 2018).
Conclusion
Generally, the choice of whether to use the traditional or modern approach when assessing a project’s risks and returns depends on the project’s specific characteristics and the decision-maker’s preferences. Overall, risks are uncertainties that must be considered when appraising capital projects.
Reference List
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Brown, D.J. (2020) Affective decision making under uncertainty: risk, ambiguity and Black Swans. Cham: Springer.
Farrar, S. (2020) ‘Capital investment appraisal,’ Tax and Optimal Capital Budgeting Decisions, pp. 41–61. Web.
Kengatharan, L. (2018) ‘Capital budgeting theory and practice: A review and agenda for future research,’ American Journal of Economics and Business Management, 1(1), pp. 20–53. Web.
Malenko, A. (2018) ‘Optimal Dynamic Capital Budgeting,’ The Review of Economic Studies, 86(4), pp. 1747–1778. Web.
Michelon, P.de, Lunkes, R.J. and Bornia, A.C. (2020) ‘Capital budgeting: A systematic review of the literature,’ Production, 30. Web.
Miller, R.A. (2022) ‘Uncertainty in capital budgeting: Five particular safety‐(or danger‐) margins from the NPV formula,’ Journal of Applied Corporate Finance, 34(3), pp. 110–115. Web.
Mubashar, A. and Tariq, Y.B. (2019) ‘Capital budgeting decision-making practices: Evidence from Pakistan,’ Journal of Advances in Management Research, 16(2), pp. 142–167. Web.
Senthilnathan, S. (2020) ‘Capital budgeting – The Tools for Project Evaluation,’SSRN Electronic Journal [Preprint]. Web.
Szpiro, G. (2020) Risk, choice, and uncertainty: three Centuries of economic decision-making. New York: Columbia University Press.
Turner, M.J. and Coote, L.V. (2018) ‘Incentives and monitoring: Impact on the financial and non-financial orientation of capital budgeting,’ Meditari Accountancy Research, 26(1), pp. 122–144. Web.