L04 Risk and Uncertainty

L04 Risk and Uncertainty - Capital Budgeting Risk and...

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1 Copyright ©2003 Stephen G. Buell Capital Budgeting Risk and Uncertainty Copyright ©2003 Stephen G. Buell Risk and Uncertainty Risk L the possibility that actual returns will deviate from expected returns Risk L situations in which a probability distribution of possible outcomes can be estimated Uncertainty L worse, not enough information available Copyright ©2003 Stephen G. Buell Probability distribution of expected outcomes
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2 Copyright ©2003 Stephen G. Buell Initial measure of risk occurring of y probabilit outcome possible outcomes possible of number ) ( flows cash expected of deviation Standard 1 2 1 j j th j j m j j j m j j CF P j CF m P CF CF P CF CF = = = = - = = = s s Copyright ©2003 Stephen G. Buell Improved measure of risk 075 . 4000 300 while 300 . 1000 300 that. show to Need riskier. is y x Intuitivel 4000 and 300 versus 1000 and 300 Consider cv basis relative a on dispersion puts (cv) variation of t Coefficien y x = = = = = = = = = y x y x cv cv CF CF CF s s s Copyright ©2003 Stephen G. Buell Forecasted cash flows 20% 800 Boom j = 3 50% 300 Normal j = 2 30% 100 Recession j = 1 P j CF j State of Economy
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Copyright ©2003 Stephen G. Buell Computing coefficient of variation 72 . 340 76 . 245 76 . 245 20 . ) 340 800 ( 50 . ) 340 300 ( 30 . ) 340 100 ( 340 ) 800 ( 20 . ) 300 ( 50 . ) 100 ( 30 . 2 2 2 = = = = - + - + - = = + + = CF CV CF s s s Copyright ©2003 Stephen G. Buell Required hurdle rate k' acceptable be it to for rate hurdle higher a requiring by project riskier a Penalize" " project the of risk forecasted the of function a is ' return of rate Required ) ( ) ( ' k CF f risk f k s = = Copyright ©2003 Stephen G. Buell Alternate methods for incorporating risk into capital budgeting
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This note was uploaded on 02/07/2011 for the course FIN 125 taught by Professor Buell during the Spring '08 term at Lehigh University .

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L04 Risk and Uncertainty - Capital Budgeting Risk and...

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