Date post: | 08-Jul-2015 |
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Capital Budgeting
Introduction and Project Risk
Capital Budgeting Is the process of:
• Measuring• Evaluating• Selecting long-term investment
opportunity
Project Risk
Capital undertakings have elements of both
• Risk
• Reward
Risk: The possibility of loss or other unfavorable
Results that derives from uncertainty
implicitly in future outcomes
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Definition of risk
• Incomplete or incorrect analysis of the project,
including failure to incorporate revenue or cost
elements or mis-estimation of those elements.
• Unanticipated actions of customers, suppliers,
and competitors, including changing prices of
resources, and the advent of new technology.
A particular project may be at risk from the following:
• Unanticipated changes in laws, regulations, or
other political changes.
• Unanticipated macroeconomic changes, including
changes in interest rates, inflation/deflation rates,
tax rates, and currency exchange rates.
A particular project may be at risk from the following:
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REDUCING RISK
An alternate content page.
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WITH A LARGE NUMBER OF DIVERSE PROJECTS, THE UNFAVORABLE OUTCOMES EXPERIENCED BY SOME PROJECTS ARE MORE LIKELY TO BE OFFSET BY FAVORABLE OUTCOMES EXPERIENCED BY OTHER PROJECTS.
In effect, having a diverse portfolio of projects reduces the aggregate risk to the firm in much the same manner that diversification of securities holdings reduces the risk in a securities investment portfolio.
The risk associated with an increase in interest rates would apply similarly to all long-term projects
An unanticipated increase in interest rates would tend to result in lower returns from all long-term projects.
In most cases, risks derived from the macroeconomic environment cannot be reduced by project diversification
Certain Risks are likely to impact most projects in the same manner.
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Risk-Reward Relationship
Stage 1
Stage 2
Stage 3Reward:
• The benefit expected
or required from investment of resources in capital
project and other undertakings.
• The relationship between risk And reward that :
The greater the perceived risk,
The greater the expected reward.
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The risk-reward relationship
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Chart Title
Series 1 Series 2 Series 3
The risk-reward relationship is familiar: the greater the perceived risk, the greater the expected reward. Thus, the relationship between risk and reward is positive and can be shown graphically as:
The rate of return earned on a firm's capital projects must be equal or greater than the rate of return required to attract and maintain investors' capital.
The relationship between a firm's capital projects and the firm's capital that funds those projects.
In the U.S. the risk-free rate of return normally is measured by the rates on U.S.
• Treasury securities (bills and notes). paid on these securities
without incurring the risk associated with commercial Investors
or firms could earn the rates securities or with project undertakings.
• The return expected above the risk-free rate, called the risk premium, depends on the perceived risk inherent in an investment opportunity-securities, projects.
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Hurdle Rate or Discount rate
The resulting weighted average is the rate of return that a firm must expect to earn on a project it undertakes.
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The rate of return expected solely for the deferred current consumption that results from making an investment.
Risk-free rate of return