Risks related to capital budgeting

Risk diversified away by shareholders as securities

Info iconThis preview shows page 1. Sign up to view the full content.

View Full Document Right Arrow Icon
This is the end of the preview. Sign up to access the rest of the document.

Unformatted text preview: sk diversified away by shareholders as securities are combined to form diversified portfolio. Three Measures of a Project’s Risk Three Project Standing Alone Risk Project’s Contributionto-Firm Risk Systematic Risk for diversified stock holders Risk diversified away within firm as this project is combined with firm’s other projects and assets. Risk diversified away by shareholders as securities are combined to form diversified portfolio. A Breakdown of Risk What is the most relevant measure of risk? What Given that the firm’s primary objective is to Given maximize stockholder value, what ultimately matters is the risk that a project imposes on stockholders. Because stockholders are generally diversified, market risk is theoretically the most relevant measure of risk. Market risk is important because beta affects the cost of capital which, in turn, affects stock price. Project’s Contribution-to-Firm Risk is also important for 3 reasons important Undiversified stockholders are more concerned about Undiversified corporate risk than about market risk. corporate Empirical studies of the determinants of required rates of Empirical return generally find that both market and corporate risk affect stock prices. stock The firm’s stability is important to its managers, workers, The customers, suppliers, and creditors, as well as to the community in which it operates. Firms that are in serious danger of bankruptcy, or even of suffering low profits and bankruptcy or reduced output have difficulty attracting and retaining good managers and workers. These factors tend to reduce risky firms 'profitability and hence their stock prices, and this makes corporate risk significant. corporate Your job for this chapter Your Step 2:Incorporate risk into capital-budgeting :Incorporate analysis. analysis. Incorporating Risk into Capital Budgeting Capital Two Methods: Certainty Equivalent Approach Certainty (adjust CFs & keep risk-free discount rate) discount Risk-Adjusted Discount Rate Risk-Adjusted (adjust discount rate) (adjust How can we adjust this model to take risk into account?...
View Full Document

This document was uploaded on 02/03/2014.

Ask a homework question - tutors are online