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The Appendix
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Slide4]
The Role of Risk in Capital Budgeting
The Role of Risk in Capital Budgeting
The Relationship Between Risk and Capital Budgeting
Assessing Stand-Alone Risk
Risk and Return
Scenario and Simulation Assessments
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Factors Impacting Capital Budgeting
Slide5]
The Role of Risk in Capital Budgeting
The Role of Risk in Capital Budgeting
(continued)
Other Considerations in Capital Budgeting
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Slide6Risks Involved in Capital Budgeting
Risk Aversion
Approaches to Assessing Risk The Relationship Between Risk and Capital Budgeting
The Role of Risk in Capital Budgeting
>
The Relationship Between Risk and Capital Budge...
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Slide7Overview of How to Assess Stand-Alone Risk
Assessing Stand-Alone Risk
The Role of Risk in Capital Budgeting
>
Assessing Stand-Alone Risk
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Slide8Risk and Return Considerations
Risk and Return
The Role of Risk in Capital Budgeting
>
Risk and Return
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Slide9Sensitivity Analysis
Scenario Analysis
Monte Carlo Simulation Decision Trees Scenario and Simulation Assessments
The Role of Risk in Capital Budgeting
>
Scenario and Simulation Assessments
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Slide10Risk Adjusting the Discount Rate
Risk Adjusting for the Time Horizon
Factors Impacting Capital Budgeting
The Role of Risk in Capital Budgeting
> Factors Impacting Capital Budgeting
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Slide11Other Considerations in Capital Budgeting
Other Considerations in Capital Budgeting
The Role of Risk in Capital Budgeting
>
Other Considerations in Capital Budgeting
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Appendix
Slide13Key terms
analysis A process of dismantling or separating into constituent elements in order to study the nature, function, or meaning.Behavioral Finance
Field that focuses on human risk-aversion, asymmetric regret, and other ways that human financial behavior varies from what analysts call "rational".capital budgeting The planning process used to determine whether an organization's long term investments, such as new machinery, replacement machinery, new plants, new products, and research development projects are worth pursuing.correlation coefficient
Any of the several measures indicating the strength and direction of a linear relationship between two random variables.discounted cash flow An estimated future cash flow discounted by the probability of receiving that cash flow.distribution A probability distribution; the set of relative likelihoods that a variable will have a value in a given interval.inflation An increase in the general level of prices or in the cost of living.net present value
the present value of a project or an investment decision determined by summing the discounted incoming and outgoing future cash flows resulting from the decisionnode A vertex point on a decision tree. Other branches may extend from it; if none do, it is an end node.
parameter A variable kept constant during an experiment, calculation, or similar.political risk
the potential loss for a company due to nonmarket factors as macroeconomic and social policiesprobability distribution A function of a discrete random variable yielding the probability that the variable will have a given value
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The Role of Risk in Capital Budgeting
Slide14propensity
A tendency, preference, or attraction.risk The potential that a chosen action or activity (including the choice of inaction) will lead to a loss (an undesirable outcome).
risk The potential that a chosen action or activity (including the choice of inaction) will lead to a loss (an undesirable outcome).Risk Aversion Risk Aversion is a concept that addresses how people will react to a situation with uncertain outcomes. It attempts to measure the tolerance for risk and uncertainty. Risk aversion is the reluctance of a person to accept a bargain with an uncertain payoff rather than another bargain with a more certain, but possibly lower, expected payoff.salvage value
The estimated value of an asset at the end of its useful life.scenario A set of factors that can affect the consequences of an action. The environment.scenario analysis a process of analyzing possible future events by considering alternative possible outcomessensitivity analysis the study of how the uncertainty in the output of a mathematical model or system can be apportioned to different sources of uncertainty in its inputssystematic risk
The risk associated with an asset that is correlated with the risk of asset markets generally, often measured as its beta.time horizon The period of time the asset is expected to be held or a project is expected to last.
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The Role of Risk in Capital Budgeting
Slide15Scenario Analysis
This scenario analysis shows how changes in factors like yield and transport cost can affect profits.
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Wikimedia.
"Sensitivity-analysis."
CC BY-SA
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The Role of Risk in Capital Budgeting
Slide16High dividend gambles
Risk aversion can be applied to many different situations including investments, lotteries, and any other situations with uncertain outcomes.
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Wikimedia.
"Wikimedia."
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http://wikimedia.org
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The Role of Risk in Capital Budgeting
Slide17Monte Carlo Simulation
By running many simulations based on the probability or distribution of an input (x), the analyst can see the average output (y). This is done for multiple inputs at once to find out how they affect the output.
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Wikimedia.
"File:Spurious regression.svg - Wikimedia Commons."
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http://commons.wikimedia.org/w/index.php?title=File:Spurious_regression.svg&page=1
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The Role of Risk in Capital Budgeting
Slide18Performance of Stocks, Bonds and Bills
This graph gives an illustration of investing a dollar in different asset classes in the market from 1926 to the end of 2007.
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Wikimedia.
"Performance of stocks, bonds and bills."
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The Role of Risk in Capital Budgeting
Slide19Project Cash Flow With Uncertainty
Projects with real options can be evaluated using a range of possible profits.
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Wikimedia.
"Datar Mathews Real Option Method Wikipedia Fig 1 Typical Project Cash Flow with Uncertainty."
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The Role of Risk in Capital Budgeting
Slide20Coefficient of Variation
The coefficient of variation, an example of which is plotted in this graph, can be used to measure the ratio of volatility to expected return.
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Wikimedia.
"Diagram of coefficient of variation versus deviation in reference ranges erroneously not established by log-normal distribution."
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The Role of Risk in Capital Budgeting
Slide21Inflation
Inflation is a rise in the general level of prices of goods and services in an economy over a period of time.
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The Role of Risk in Capital Budgeting
Slide22Possible Business Risks
This chart represents a list of the possible risks involved in running an organic business. Risks such as these affect sales, which in turn affect the amount of operating leverage a company should utilize.
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"Possible-risks."
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The Role of Risk in Capital Budgeting
Slide23Discounting Curves
This chart illustrates the devaluation of capital over time as a result of various discount rates.
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Wikimedia.
"Economics_of_climate_change_chapter3_discounting_curves.png."
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The Role of Risk in Capital Budgeting
Slide24Decision Tree
This decision tree highlights the outcomes of different investing strategies. Next to the terminal nodes is blue text with the yield and gain.
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Wikipedia.
"Investment decision Insight."
Public domain
http://en.wikipedia.org/wiki/File:Investment_decision_Insight.png
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The Role of Risk in Capital Budgeting
Slide25Inspecting Equipment
Risk can be assessed in a number of ways, and is a critical step in capital budgeting and planning, as well as project management.
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Flickr.
"All sizes | Trevallyn assessment | Flickr - Photo Sharing!."
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http://www.flickr.com/photos/hydropower/6234166253/sizes/z/in/photostream/
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The Role of Risk in Capital Budgeting
Slide26Sensitivity of a Variable
Sensitivity analysis determines how much an output is expected to change due to changes in a variable or parameter. In this case, the output (y-axis) decreases exponentially with an increase in the input (x-axis). This is mapped out for each input.
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Flickr.
"All sizes | exponential curve data | Flickr - Photo Sharing!."
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The Role of Risk in Capital Budgeting
Slide27Attribution
Wikipedia.
"Real options analysis." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Real_options_analysis
Wikipedia. "salvage value." CC BY-SA 3.0 http://en.wikipedia.org/wiki/salvage%20value
Wiktionary.
"time horizon." CC BY-SA 3.0
http://en.wiktionary.org/wiki/time_horizon
Managing Money. "ManagingMoney.com Money Blog: Asset Allocation Tips." CC BY
http://www.managingmoney.com/weblog/2007/01/asset_allocation_tips.html
Wikipedia.
"Risk aversion."
CC BY-SA 3.0
http://en.wikipedia.org/wiki/Risk_aversion
Wikipedia.
"Risk Aversion." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Risk%20AversionWikipedia.
"RNPV." CC BY-SA 3.0
https://en.wikipedia.org/wiki/RNPVWikipedia.
"Net present value." CC BY-SA 3.0 https://en.wikipedia.org/wiki/Net_present_value
Wikipedia. "Discounting - Discount rate." CC BY-SA 3.0
https://en.wikipedia.org/wiki/Discounting#Discount_rateWiki Treasurers. "Discounted cash flow." CC BY-SA 3.0 https://wiki.treasurers.org/wiki/Discounted_cash_flow
Wiki Treasurers. "Discount rate." CC BY-SA 3.0
https://wiki.treasurers.org/wiki/Discount_rate
Wikipedia.
"Risk."
CC BY-SA 3.0
http://en.wikipedia.org/wiki/Risk%23Risk_assessment_and_analysis
Wikipedia.
"Risk management."
CC BY-SA 3.0
http://en.wikipedia.org/wiki/Risk_management%23Enterprise_risk_management
Wikipedia.
"Behavioral Finance."
CC BY-SA 3.0
http://en.wikipedia.org/wiki/Behavioral%20Finance
Wikipedia.
"Risk assessment."
CC BY-SA 3.0
http://en.wikipedia.org/wiki/Risk_assessment%23Risk_assessment_for_megaprojects
Wiktionary.
"risk."
CC BY-SA 3.0
http://en.wiktionary.org/wiki/risk
Wikipedia.
"Sensitivity analysis."
CC BY-SA 3.0
http://en.wikipedia.org/wiki/Sensitivity_analysis
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The Role of Risk in Capital Budgeting
Slide28Wikipedia.
"Sensitivity analysis."
CC BY-SA 3.0 http://en.wikipedia.org/wiki/Sensitivity_analysis
Wiktionary. "parameter." CC BY-SA 3.0 http://en.wiktionary.org/wiki/parameter
Wikibooks.
"Operations Research/Sensitivity analysis." CC BY-SA 3.0
http://en.wikibooks.org/wiki/Operations_Research/Sensitivity_analysis
Wikipedia. "Monte Carlo methods in finance." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Monte_Carlo_methods_in_finance
Wikipedia.
"Monte Carlo methods for option pricing."
CC BY-SA 3.0
http://en.wikipedia.org/wiki/Monte_Carlo_methods_for_option_pricing
Wikipedia.
"Monte carlo simulation."
CC BY-SA 3.0 http://en.wikipedia.org/wiki/Monte_carlo_simulation%23Finance_and_businessWiktionary.
"distribution." CC BY-SA 3.0
http://en.wiktionary.org/wiki/distributionWikipedia.
"Decision tree." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Decision_tree
Boundless Learning. "Boundless." CC BY-SA 3.0
http://www.boundless.com//physics/definition/nodeWikipedia. "Beta (finance)." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Beta_(finance)
Wikipedia. "Coefficient of variation." CC BY-SA 3.0
http://en.wikipedia.org/wiki/Coefficient_of_variation
Wiktionary.
"probability distribution."
CC BY-SA 3.0
http://en.wiktionary.org/wiki/probability_distribution
Wiktionary.
"correlation coefficient."
CC BY-SA 3.0
http://en.wiktionary.org/wiki/correlation_coefficient
Wikipedia.
"Scenario analysis."
CC BY-SA 3.0
http://en.wikipedia.org/wiki/Scenario_analysis
Wikipedia.
"Scenario analysis."
CC BY-SA 3.0
http://en.wikipedia.org/wiki/Scenario_analysis
Wiktionary.
"scenario."
CC BY-SA 3.0
http://en.wiktionary.org/wiki/scenario
Boundless Learning.
"Boundless."
CC BY-SA 3.0
http://www.boundless.com//marketing/definition/analysis
Wikibooks.
"Future/Scenario."
CC BY-SA 3.0
http://en.wikibooks.org/wiki/Future/Scenario
Wikipedia.
"Risk."
CC BY-SA 3.0
http://en.wikipedia.org/wiki/Risk
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The Role of Risk in Capital Budgeting
Slide29Wikipedia.
"Sensitivity analysis."
CC BY-SA 3.0 http://en.wikipedia.org/wiki/Sensitivity_analysis
Wikipedia. "capital budgeting." CC BY-SA 3.0 http://en.wikipedia.org/wiki/capital%20budgeting
Wikipedia.
"Scenario analysis." CC BY-SA 3.0
http://en.wikipedia.org/wiki/Scenario_analysis
Wikipedia. "Scenario analysis." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Scenario_analysis
Wikipedia.
"Capital budgeting."
CC BY-SA 3.0
http://en.wikipedia.org/wiki/Capital_budgeting
Wiktionary.
"risk."
CC BY-SA 3.0 http://en.wiktionary.org/wiki/riskWiktionary. "net present value."
CC BY-SA 3.0
http://en.wiktionary.org/wiki/net_present_valueWiktionary. "propensity."
CC BY-SA 3.0 http://en.wiktionary.org/wiki/propensity
Gilad Feldman. "REAL OPTIONS THEORY [Management & Social Psychology WIKI]." CC BY-SA http://wiki.mgto.org/real_options_theory
Wikipedia. "Interest." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Interest
Wikipedia. "Beta (finance)." CC BY-SA 3.0
http://en.wikipedia.org/wiki/Beta_(finance)
Wikipedia.
"Risk aversion."
CC BY-SA 3.0
http://en.wikipedia.org/wiki/Risk_aversion
Wikipedia.
"Risk-return spectrum."
CC BY-SA 3.0
http://en.wikipedia.org/wiki/Risk-return_spectrum
Wikipedia.
"Political risk."
CC BY-SA 3.0
http://en.wikipedia.org/wiki/Political_risk
Wiktionary.
"systematic risk."
CC BY-SA 3.0
http://en.wiktionary.org/wiki/systematic_risk
Wiktionary.
"inflation."
CC BY-SA 3.0
http://en.wiktionary.org/wiki/inflation
Wikibooks.
"Real Estate Financing and Investing/Understanding Return and Risk."
CC BY-SA 3.0
http://en.wikibooks.org/wiki/Real_Estate_Financing_and_Investing/Understanding_Return_and_Risk%23Risk_and_the_Risk-Return_Trade_Off
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The Role of Risk in Capital Budgeting