15.5 a. How is project risk incorporated into a capital budgeting analysis? b. Suppose that two...

15.5 a. How is project risk incorporated into a capital budgeting analysis?
b. Suppose that two mutually exclusive projects are being evaluated
on the basis of cash costs. How would risk adjustments be
applied in this situation?

Expert Solution

Answer to part a

The project risk is inevitable with the capital budgets analysis. When an investment has to be made by the company, the management evaluates the risk associated with the project and make the decision in favour of the project which has least risk associated and maximium benefit. The various risks include cash flows not being paid in time as pre agreed, the risk of the investee company not functioning well and also the management sinking the invested funds in risky projects which may not give results as desired or expected. By incorporating risk in capital budgeting, investors can minimize losses.

Answer to part b

When managers select from among mutually exclusive projects, that means when they opt for having one out of the two projects which are such that if one project is taken up ; the other shall not be taken. It shall have to give up rate of return for Net Present Value or may have to evaluate the Internal rate of return. The project which gives better net present value shall be taken up by the company..

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