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Risk Management in Capital Budgeting: Concepts and Methodologies

Understand and apply risk concepts in capital budgeting, from risk characterization to risk-adjusted discount rates. Learn to assess risk based on uncertainty of future cash flows using methods like standard deviation and coefficient of variation. Explore how to adjust discount rates, simulate outcomes, and test project sensitivity to key variables.

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Risk Management in Capital Budgeting: Concepts and Methodologies

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  1. Learning Objectives • Describe the concept of risk based on the uncertainty of future cash flows. (LO1) • Characterize most investors as risk averse. (LO2) • Analyze risk as standard deviation, coefficient of variation or beta. (LO3) • Integrate the basic methodology of risk-adjusted discount rates for dealing with risk in capital budgeting analysis. (LO4)

  2. LO4 Risk and the Capital Budgeting Process • adjusting the discount rate to reflect the risk level associated with an investment proposal • converting cash flows to their certainty equivalents • simulating various economic and financial outcomes with the help of a computer • testing the sensitivity of a project’s success to some key variables • using a decision tree

  3. LO4 Figure 13-5 Relationship ofrisk to discountrate

  4. LO4 Table13-3 Risk classes and associated discount rates

  5. LO4 Table 13-4Capital Budgeting Analysis

  6. LO4 Table 13-5Capital budgeting decision adjusted for risk

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