Question
In: Finance
How would a very risky investment/project be handled in the capital budgeting/cost of capital context?
How would a very risky investment/project be handled in the capital budgeting/cost of capital context?
Solutions
Expert Solution
Investors taking risks on projects have to be compensated with higher rewards. In case of very risky projects decision makers has to be cautious on few things, firstly the IRR of the project (i.e. the internal rate of return), if the Net Present Value is on the lower side and the IRR is higher than the Cost of Capital the investments should be made in the project, second is the payback period of the project, the decision maker has to consider the time horizon in which the investment pays the initial capital back to the business, third is the Profitability Index of the project if the PI exceed the value of 1, such projects should be accepted as the cash inflows always will overturn the cash outflows of the project. It has to be kept in mind that in case of a highly risky project's chances of losing money is huge and hence while making the decisions there are no half measures for the project.
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