Question

What is the essense of capital budgeting؟
What does the presence of risk imply concering returns؟
What two pieces of information does the payback convey that are absent from the other capital budgeting decision methods؟

Answer 1

Essence of capital budgeting:

b) Presence of risk implied returns

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.

What are the 3 types of project risk?

•Stand-alone risk

•Corporate risk

•Market risk Stand-alone risk

•The project’s total risk, if it were operated independently.

•Usually measured by standard deviation (or coefficient of variation).

•However, it ignores the firm’s diversification among projects and investors’ diversification among firms.

Corporate risk

•The project’s risk when considering the firm’s other projects, i.e., diversification within the firm.

•Corporate risk is a function of the project’s NPV and standard deviation and its correlation with the returns on other firm projects.Market Risk

•The project’s risk to a well-diversified investor.

•Theoretically, it is measured by the project’s beta and it considers both corporate and stockholder diversification.

Payback Method:

Focus on early payback can enhance liquidity

A longer payback period indicates capital is tied up

Shorter term forecasts