Risk in Capital Budgeting

When it comes to capital budgeting, risk refers to probability that project will proof to be unacceptable with net present value (NPV) less than zero or internal rate of return (IRR) less than cost of capital. Particularly, it refers to variability of the returns.

To find the minimum cash inflow level acceptable, we need to calculate breakeven cash inflow.

Breakeven cash inflow refers to the minimum cash inflow that it required for the project to be acceptable. It is calculated as follows:

PV – Initial investment

N – number of periods over which cash inflow is received

I – required cost of capital

Find PMT – breakeven cash inflow

Test yourself:

ABC Corporation have an option to invest in project A which requires investment of $120,000. The duration of the project is 5 years and ABC’s cost of capital is 9%. What is the breakeven cash inflow?

Solution:

We can find breakeven cash inflow of project A with the help of financial calculator.

PV: -120,000

N: 5

I: 10

Find PMT: $31,448.94

The above calculation helps us to determine that the minimum annual cash inflow that will be acceptable for project A is $31,448.94.

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