Fm12 20 - i 1 What are the three types of risk that are relevant in capital budgeting 2 How is each of these risk types measured and how do they

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Mini Case: 12 - 20 i. 1. What are the three types of risk that are relevant in capital budgeting? 2. How is each of these risk types measured, and how do they relate to one another? Answer: Here are the three types of project risk: Stand-alone risk is the project’s total risk if it were operated independently. Stand- alone risk ignores both the firm’s diversification among projects and investors’ diversification among firms. Stand-alone risk is measured either by the project’s standard deviation of NPV ( σ NPV ) or its coefficient of variation of NPV (CV NPV ). Note that other profitability measures, such as IRR and MIRR, can also be used to obtain stand-alone risk estimates. Within-firm risk is the total riskiness of the project giving consideration to the firm’s other projects, that is, to diversification within the firm. It is the contribution of the project to the firm’s total risk, and it is a function of (a) the project’s standard deviation of NPV and (b) the correlation of the projects’ returns with those of the rest
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This note was uploaded on 07/13/2011 for the course FIN 4414 taught by Professor Staff during the Spring '08 term at University of Florida.

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