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cbrisk_2 - Capital budgeting risk A reading prepared by...

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Capital budgeting & risk A reading prepared by Pamela Peterson Drake O U T L I N E 1. Introduction 2. Measurement of project risk 3. Incorporating risk in the capital budgeting decision 4. Assessment of project risk in practice 5. Summary 1. Introduction "To understand uncertainty and risk is to understand the key business problem -- and the key business opportunity." -- David B. Hertz, 1972. The capital budgeting decisions that a financial manager makes require analyzing each project's: 1. Future cash flows 2. Uncertainty of future cash flows 3. Value of these future cash flows When we look at the available investment opportunities, we want to determine which projects will maximize the value of the company and, hence, maximize owners' wealth. That is, we analyze each project, evaluating how much its benefits exceed its costs. The projects that are expected to increase owners' wealth the most are the best ones. In deciding whether a project increases shareholder wealth, we have to weigh its benefits and its 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, or 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 capital budgeting decision. We begin by describing what we mean by risk in the context of long-lived Capital budgeting & risk , a reading prepared by Pamela Peterson Drake 1
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projects. We then propose several commonly used statistical measures of capital project risk. Then we look at the relation between risk and return, specifically for capital projects. And we follow with how risk can be incorporated in the capital budgeting decision and how it is applied in practice. A. Risk Risk is the degree of uncertainty. When we estimate (which is the best we can do) what it costs to invest in a given project and what its benefits will be in the future, we are coping with uncertainty. The uncertainty arises from different sources, depending on the type of investment being considered, as well as the circumstances and the industry in which it is operating. Uncertainty may due to: Economic conditions -- Will consumers be spending or saving? Will the economy be in a recession? Will the government stimulate spending? Will there be inflation?
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