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The Role of Risk in Capital Budgeting > The Relationship Between Risk and Capital Budge...
The Relationship Between Risk and Capital Budgeting
• Risks Involved in Capital Budgeting
• Risk Aversion
• Approaches to Assessing Risk
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The Role of Risk in Capital Budgeting > The Relationship Between Risk and Capital Budge...
Risks Involved in Capital Budgeting
• Capital budgeting (or investment appraisal) is the planning process used to
determine whether an organization's long-term investments are worth pursuing.
The risk that can arise here involves the potential that a chosen action or activity
(including the choice of inaction) will lead to a loss.
• There are numerous kinds of risks to be taken into account when considering
capital budgeting. Each of these risks addresses an area in which some sort of
volatility could forcibly alter the plan of firm managers.
• There are different ways to measure and prepare to deal and plan for these risks,
including sensitivity analysis, scenario analysis, and break-even analysis among
others.
Possible Business Risks
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The Role of Risk in Capital Budgeting > The Relationship Between Risk and Capital Budge...
Risk Aversion
• Risk aversion is the reluctance of a person to accept a bargain with an uncertain
payoff rather than another bargain with a more certain, but possibly lower,
expected payoff.
• People can be risk averse, risk neutral, or risk loving. A risk averse person will
generally take a guaranteed outcome even if it has a lower expected payout than
a gamble, while a risk lover will take on the gamble unless the guaranteed payoff
is greater than the expected payoff of the gamble.
• Firm management can adopt different stances based on how risk averse they feel
they should be, given different market qualities and firm conditions. They will
make capital investments that they feel will have the best payoffs, given the risks
High dividend gambles
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involved.
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The Role of Risk in Capital Budgeting > The Relationship Between Risk and Capital Budge...
Approaches to Assessing Risk
• As risk carries so many different meanings, there are many formal methods used
to assess or to "measure" risk. Planned actions are subject to large cost and
benefit risks, so proper risk assessment and management is crucial to making
them successful.
• The assessment of risk is an integral part of risk management in general, and
includes probability studies, impact of events, taking into account the affect of
every known risk on the project, and the actions needed to resolve these issues,
should they occur.
• Behavioral finance focuses on risk-aversion, and other ways that financial
behavior varies from what analysts call rational. Here, risk is uncertainty
Inspecting Equipment
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associated with return on assets. In enterprise risk management, risk is an event
that can have negative influences on the enterprise in question.
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Appendix
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The Role of Risk in Capital Budgeting
Key terms
• Behavioral Finance Field that focuses on human risk-aversion, asymmetric regret, and other ways that human financial
behavior varies from what analysts call "rational".
• capital budgeting The planning process used to determine whether an organization's long term investments, such as new
machinery, replacement machinery, new plants, new products, and research development projects are worth pursuing.
• risk The potential that a chosen action or activity (including the choice of inaction) will lead to a loss (an undesirable outcome).
• risk The potential that a chosen action or activity (including the choice of inaction) will lead to a loss (an undesirable outcome).
• Risk Aversion Risk Aversion is a concept that addresses how people will react to a situation with uncertain outcomes. It
attempts to measure the tolerance for risk and uncertainty. Risk aversion is the reluctance of a person to accept a bargain with
an uncertain payoff rather than another bargain with a more certain, but possibly lower, expected payoff.
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The Role of Risk in Capital Budgeting
Possible Business Risks
This chart represents a list of the possible risks involved in running an organic business. Risks such as these affect sales, which in turn affect the amount
of operating leverage a company should utilize.
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The Role of Risk in Capital Budgeting
Inspecting Equipment
Risk can be assessed in a number of ways, and is a critical step in capital budgeting and planning, as well as project management.
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The Role of Risk in Capital Budgeting
High dividend gambles
Risk aversion can be applied to many different situations including investments, lotteries, and any other situations with uncertain outcomes.
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The Role of Risk in Capital Budgeting
Which of the following is a type of risk that should be considered
during the capital budgeting process?
A) Corporate risk.
B) Market risk.
C) All of these answers.
D) Stand-alone risk.
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The Role of Risk in Capital Budgeting
Which of the following is a type of risk that should be considered
during the capital budgeting process?
A) Corporate risk.
B) Market risk.
C) All of these answers.
D) Stand-alone risk.
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The Role of Risk in Capital Budgeting
John is offered the option to take $50 now or risk it all on a coin
flip, where heads gets him $100 but tails will get him nothing.
John takes the coin flip. Prior to the flip, John is offered
progressively higher "guaranteed payment, which John refuses
until the guaranteed amount is $70. John ______.
A) is risk averse.
B) is risk neutral.
C) is a risk seeker.
D) 's risk aversion cannot be determined.
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The Role of Risk in Capital Budgeting
John is offered the option to take $50 now or risk it all on a coin
flip, where heads gets him $100 but tails will get him nothing.
John takes the coin flip. Prior to the flip, John is offered
progressively higher "guaranteed payment, which John refuses
until the guaranteed amount is $70. John ______.
A) is risk averse.
B) is risk neutral.
C) is a risk seeker.
D) 's risk aversion cannot be determined.
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The Role of Risk in Capital Budgeting
Which of the following does NOT correctly define risk in the given
context?
A) In enterprise risk management, risk is a possible event that can have a
negative impact.
B) For financial companies, risk is the combination of credit, interest,
market and operational risk.
C) In behavioral finance, risk is the degree of uncertainty associated with
a person taking an action.
D) All of these answers.
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The Role of Risk in Capital Budgeting
Which of the following does NOT correctly define risk in the given
context?
A) In enterprise risk management, risk is a possible event that can have a
negative impact.
B) For financial companies, risk is the combination of credit, interest,
market and operational risk.
C) In behavioral finance, risk is the degree of uncertainty associated with
a person taking an action.
D) All of these answers.
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Boundless - LO. "Boundless." CC BY-SA 3.0 http://www.boundless.com/
The Role of Risk in Capital Budgeting
Attribution
• Wikipedia. "Risk aversion." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Risk_aversion
• Wikipedia. "Risk Aversion." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Risk%20Aversion
• Wikipedia. "Risk management." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Risk_management#Enterprise_risk_management
• Wikipedia. "Risk." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Risk#Risk_assessment_and_analysis
• Wikipedia. "Risk assessment." CC BY-SA 3.0
http://en.wikipedia.org/wiki/Risk_assessment#Risk_assessment_for_megaprojects
• Wiktionary. "risk." CC BY-SA 3.0 http://en.wiktionary.org/wiki/risk
• Wikipedia. "Behavioral Finance." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Behavioral%20Finance
• Wikipedia. "Capital budgeting." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Capital_budgeting
• Wikipedia. "Risk." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Risk
• Wikipedia. "Sensitivity analysis." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Sensitivity_analysis
• Wikipedia. "Scenario analysis." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Scenario_analysis
• Wikipedia. "Scenario analysis." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Scenario_analysis
• Wiktionary. "risk." CC BY-SA 3.0 http://en.wiktionary.org/wiki/risk
• Wikipedia. "capital budgeting." CC BY-SA 3.0 http://en.wikipedia.org/wiki/capital%20budgeting
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