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Risk and Capital Budgeting

Risk and Capital Budgeting

Author: Sophia Media

Differentiate between examples of operational, financial, or market risks.

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[MUSIC PLAYING] When we are talking about the capital budgeting process, a firm has to take into account the number of potential risks of the investments not panning out. Whether this is for new machinery, replacement machinery, or new buildings, or new products, or new research and development, it needs to consider how it plans to address these risks.

Let's define a risk. A risk is the potential probability that an action or activity or even the choice of not taking an action will lead to a loss. This implies there exists a choice, and that we have an influence on the outcome at some point. Potential losses themselves may be called risks.

There are several classifications of risks. Let's take a look at some of them. Operational risks are those that exist in the execution of the core business. Let's consider an example of an organic food supplier. Operational risk could include weather conditions, farmers selling their goods elsewhere, quality deterioration during storage, damage during transportation, and others.

The company needs to plan to take measures against each of these. For example, for weather, they should plan to provide technical assistance to farmers, and calculate different scenarios for planting. And what to do in the case of drought or flooding.

To avoid having farmers selling to other buyers, they want to be sure to offer farmers an attractive part price, and pay them on time. They also need to understand how other buyers are competing with them. To prevent quality deterioration, they need to make sure they choose suitable facilities for storage, keeping it clean and dry with windows closed and protected against pests.

For transportation, they should use a reliable transportation service, making sure the drug is clean, and that nothing else is loaded up. If it is being exported, the company needs to take care that the container is well loaded, and it's officially insured by the importer.

The second type of risk is the financial risk. Examples of this for our organic food supplier is payments to farmers disappearing along the way. Or the profit margin not being large enough to cover operational costs. Not having enough credit to maintain cash flows. Buyers that do not pay after they receive the product.

Steps to be taken here could include handling payments by bank accounts, most likely electronically, that's very common now. Margins could be protected by increasing efficiencies, and reducing production costs per unit. Credit could be secure by making sure trade loans are secured and available on time. And you should also know the credit worthiness of your customers, perhaps using letters of credit.

The third type of risk needs to be considered is market risk. This includes things like demand for products slowing with no buyer being able to be found. Clients not honoring their contracts, or not buying at the volume they are committed to.

Competitors offering products at lower prices or better quality. And the sudden increase in local prices. Sales prices for the product decrease. Or fluctuations of the exchange rate or other currencies may impact the business. For each of these, the organic food distributor has to have a tactical plan to consider all of these externalities and others.

Let's review the three types of risk that a company must try to mitigate. They are operational risks, which include those coming out of the core business, and include issues that affect production and distribution of products and services. There are financial risks that involve how well a company manages its short term credit, and its account receivables, and its collections from customers. And finally, there is market risk, which are changes in the external environment that impact the demand for products and services.

This is Dr. Bob Nolley, and I'll see you in the next lesson.