Question

Capital budgeting decisions are risky. For this discussion question: 

Research the risks associated with capital budgeting and identify the three that you believe are the most significant risks.

Describe these risks and support your assertion with specific reasons. 

Answer 1

The Statement is true as Capital Budgeting decisions are risky.

These Risks are as follows -

• Corporate risk
• International risk (including currency risk)
• Industry-specific risk
• Market risk
• Stand-alone risk
• Project-specific risk

The three most significant risks associated with capital budgeting are -

1. Market risk (Beta Risk)

2. Stand-alone risk

3. Corporate risk

1. Stand-alone risk -

The project's risk if it were the firm's only asset and there were no shareholders is called stand alone risk.

It ignores both firm and shareholder diversification.

It is measured by CV of NPV, IRR, MIRR

Stand-alone risk is the easiest to measure and the most intuitive. Core projects are highly correlated with other assets, so stand-alone risk generally reflects corporate risk.
If the project is highly correlated with the economy, stand-alone risk also reflects market risk.

2. Corporate risk -

It reflects the project's effect on corporate earnings stability.

It is measured by project's corporate beta.

It considers firm's other assets.

Reflects the project's effect on corporate earning stability. Considers firm's other assets. Depends on the project's alpha, and it correlation, beta with returns on firms other assets. Measure by the project's corporate beta.

Creditors customers, suppliers and employees are more affected by corporate risk

3. Market risk -

It reflects the project's effect on a well diversified stock portfolio.

It takes account of stockholder's other assets.

It is measured by project's market beta.

Market risk is theoretically best in most situations. It Reflects the project's effect on a well-diversified stock portfolio. Takes account of stockholder's other assets. Depends on projects alpha and correlation with the stock market Measured by the project's beta.