This document discusses capital budgeting and project risk. Capital budgeting is the process of measuring, evaluating, and selecting long-term investment opportunities. Capital projects have elements of both risk and reward. There are various types of risks that can impact a project, such as incomplete analysis, unanticipated actions from other parties, and unforeseen economic changes. Diversifying a portfolio of projects can help reduce overall risk to the firm. While some risks can be reduced through diversification, risks from macroeconomic factors generally cannot be diversified away. The relationship between risk and reward is positive - the greater the perceived risk of a project, the greater expected reward is required to undertake it.

1. Capital Budgeting
Introduction and Project Risk

2. Capital Budgeting
Is the process of:
• Measuring
• Evaluating
• Selecting long-term investment
opportunity

3. Project Risk
Capital undertakings have elements of both
• Risk
• Reward
Risk: The possibility of loss or other unfavorable
Results that derives from uncertainty
implicitly in future outcomes

4. Definition of risk
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5. A particular project may be at risk from
the following:
• Incomplete or incorrect analysis of the project,
including failure to incorporate revenue or cost
elements or mis-estimation of those elements.
• Unanticipated actions of customers, suppliers,
and competitors, including changing prices of
resources, and the advent of new technology.

6. A particular project may be at risk from
the following:
• Unanticipated changes in laws, regulations, or
other political changes.
• Unanticipated macroeconomic changes,
including
changes in interest rates, inflation/deflation rates,
tax rates, and currency exchange rates.

7. An alternate content page.
REDUCING RISK
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8. In effect, having a diverse portfolio of projects reduces the
aggregate risk to the firm in much the same manner that
diversification of securities holdings reduces the risk in a securities
investment portfolio.
WITH A LARGE NUMBER OF DIVERSE PROJECTS, THE UNFAVORABLE OUTCOMES EXPERIENCED
BY SOME PROJECTS ARE MORE LIKELY TO BE OFFSET BY FAVORABLE OUTCOMES EXPERIENCED
BY OTHER PROJECTS.
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9. Certain Risks are likely to impact most projects
in the same manner.
The risk associated
with an increase in
interest rates
would apply
similarly to all long-term
projects
An unanticipated
increase in interest
rates would tend to
result in lower
returns from all
long-term projects.
In most cases, risks
derived from the
macroeconomic
environment cannot
be reduced by project
diversification

10. Risk-Reward
Relationship
Stage 1
Stage 2
Stage 3
Reward:
• The benefit expected
or required from
investment of resources in
capital
project and other
undertakings.
• The relationship
between risk And
reward that :
The greater the perceived
risk,
The greater the expected
reward.
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11. The risk-reward
relationship
6
5
4
3
2
1
0
Chart Title
Series 1 Series 2 Series 3
The risk-reward
relationship is
familiar: the greater
the perceived risk,
the greater the
expected reward.
Thus, the relationship
between risk and
reward is positive
and can be shown
graphically as:
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12. The relationship between a firm's capital projects
and the firm's capital that funds those projects.
The rate of return earned on a firm's
capital projects must be equal or greater
than the rate of return required to attract
and maintain investors' capital.

13. In the U.S. the risk-free rate of return normally is
measured by the rates on U.S.
• Treasury securities (bills and notes). paid on these securities
without incurring the risk associated with commercial Investors
or firms could earn the rates securities or with project
undertakings.
• The return expected above the risk-free rate, called the risk
premium, depends on the perceived risk inherent in an
investment opportunity-securities, projects.

14. Hurdle Rate or Discount rate
The resulting weighted average is the rate of return
that a firm must expect to earn on a project it
undertakes.
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15. Risk-free rate of return
The rate of return expected solely
for the deferred current
consumption that results from
making an investment.
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