Unformatted text preview: ts costs. The costs are:
• the cash flow necessary to make the investment (the investment outlay) and
the opportunity costs of using the cash we tie up in this investment. The benefits are the future cash flows generated by the investment. But we know that anything in the
future is uncertain, so we know those future cash flows are not certain. Therefore, for an evaluation of
any investment to be meaningful, we must represent how much risk there is that its cash flows will differ
from what is expected, in terms of the amount and the timing of the cash flows. Risk is the degree of
uncertainty. We can incorporate risk in one of two ways:
• we can discount future cash flows using a higher discount rate, the greater the cash flow's risk,
we can require a higher annual return on a project, the greater the cash flow's risk. And, of course, we must incorporate risk into our decisions regarding projects that maximize owners'
wealth. In this reading, we look at the sources of cash flow uncertainty and how to incorporate risk in the
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This note was uploaded on 02/07/2014 for the course MIS 304 taught by Professor Mejias during the Spring '07 term at Arizona.
- Spring '07