A Critical Component Of Capital Budgeting Is Risk Analysis

1104 WordsApr 8, 20155 Pages
The decision of a firm to merge or acquire another firm comes with a tremendous amount of due diligence. Due diligence in, not simply acquiring all of the available knowledge that it can regarding the company it seeks to acquire, but also understanding the financial health of themselves and their ability to acquire another firm and benefit from the potential synergies realized. Companies must also assess the risks involved of the potential acquisition, and if the numbers prove worthwhile, decide how the company plans to fund the transaction. Many companies hesitate in making such major transaction decisions, however “mergers and acquisitions are the lifeblood of growth” (DiPietro, 2010, p. 18). A critical component of capital budgeting is risk analysis (Correia, 2012). Risk analysis includes assessing risk and adjusting for risk in order to measure return variability and the probability of not reaching the required rate of return that deems and investment a worthy choice (Correia, 2012). This practice, called sensitivity analysis, becomes compulsory to any firm that desires making sound investment and capital structure decisions. The theory of capital budgeting suggests that firms employ discounted cash flow (DCF) techniques in order to select investment projects (Correia, 2012). A theoretically sound and accepted DCF method is net present value (NPV). Money earned today is worth more than money earned in the future, and the NPV method takes in to account the time value of
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