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Healthcare Finance: An Introduction to Accounting & Financial Management,Sixth Editionby Louis C. Gapenski and Kristin L. ReiterHealth Administration Press. (c) 2016. Copying Prohibited.Reprinted for Personal Account, York University[email protected]Reprinted with permission as a subscription benefit of Skillport,All rights reserved. Reproduction and/or distribution in whole or in part in electronic,paper or other formswithout written permission is prohibited.
Chapter 15: Project Risk AnalysisLearning ObjectivesAfter studying this chapter, readers will be able toDescribe the three types of risk relevant to capital budgeting decisions.Describe the advantages and disadvantages of sensitivity analysis.Discuss the advantages and disadvantages of scenario analysis.Explain the advantages and disadvantages of Monte Carlo simulation.Conduct a project risk assessment.Incorporate risk into the capital budgeting decision process.Discuss the concept of capital rationing.IntroductionChapter 14 covers the basics of capital budgeting, including cash flow estimation, breakeven analysis, and return oninvestment (ROI) (profitability) measures. This chapter extends the discussion of capital budgeting to include risk analysis,which is composed of three elements: defining the type of risk relevant to the project, measuring the project's risk, andincorporating the risk assessment into the capital budgeting decision process. Although risk analysis is a key element in allfinancial decisions, the importance of capital investment decisions to a healthcare business's success or failure makes riskanalysis vital in such decisions.The higher the risk associated with an investment, the higher its required rate of return. This principle is just as valid forhealthcare businesses that make capital expenditure decisions as it is for individuals who make personal investment decisions.Thus, the ultimate goal in project risk analysis is to ensure that the cost of capital used as the discount rate in a project's ROIanalysis properly reflects the riskiness of that project. The corporate cost of capital, which is covered in detail in Chapter 13,reflects the cost of capital to the organization based on its aggregate risk—that is, based on the riskiness of the firm's averageproject.In project risk analysis, a project's risk is assessed relative to the firm's average project: Does the project under considerationhave average risk, below-average risk, or above-average risk? The corporate cost of capital is then adjusted to reflect anydifferential risk, resulting in a project cost of capital. In general, above-average-risk projects are assigned a project cost ofcapital that is higher than the corporate cost of capital, average-risk projects are evaluated at the corporate cost of capital, andbelow-average-risk projects are assigned a discount rate that is less than the corporate cost of capital. (Note that when capital