{"id":649,"date":"2023-03-28T16:47:03","date_gmt":"2023-03-28T16:47:03","guid":{"rendered":"https:\/\/pressbooks.ccconline.org\/ppscacc2010principlesoffinance\/chapter\/the-relationship-between-risk-and-capital-budgeting-boundless-finance-course-hero\/"},"modified":"2023-04-03T04:03:44","modified_gmt":"2023-04-03T04:03:44","slug":"the-relationship-between-risk-and-capital-budgeting-boundless-finance-course-hero","status":"publish","type":"chapter","link":"https:\/\/pressbooks.ccconline.org\/ppscacc2010principlesoffinance\/chapter\/the-relationship-between-risk-and-capital-budgeting-boundless-finance-course-hero\/","title":{"raw":"The Relationship Between Risk and Capital Budgeting","rendered":"The Relationship Between Risk and Capital Budgeting"},"content":{"raw":"<div id=\"block_ssi-global_HeaderFragment\" class=\"\"><header class=\"gh-flex gh-justify-between gh-items-center gh-bg-white gh-py-4 gh-shadow gh-z-[1299] gh-px-16 gh-relative\">\r\n<div class=\"gh-flex gh-flex-1 gh-items-center\"><\/div>\r\n<\/header><\/div>\r\n<div id=\"block_app\">\r\n<div class=\"articleBody\">\r\n<h2>Risks Involved in Capital Budgeting<\/h2>\r\n<div class=\"articleContent\">\r\n<div class=\"boundless-concept\">\r\n\r\nThe process of capital budgeting must take into account the different risks faced by corporations and their managers.\r\n<div class=\"textbox learning-objectives\">\r\n<h3>Learning Objectives<\/h3>\r\nIdentify the different risks that must be accounted for in the capital budgeting process\r\n\r\n<\/div>\r\n<div class=\"textbox key-takeaways\">\r\n<h3>Key Takeaways<\/h3>\r\n<h4>Key Points<\/h4>\r\n<ul>\r\n \t<li>Capital budgeting (or investment appraisal) is the planning process used to determine whether an organization's long-term investments are worth pursuing. The risk that can arise here involves the potential that a chosen action or activity (including the choice of inaction) will lead to a loss.<\/li>\r\n \t<li>There are numerous kinds of risks to be taken into account when considering capital budgeting. Each of these risks addresses an area in which some sort of volatility could forcibly alter the plan of firm managers.<\/li>\r\n \t<li>There are different ways to measure and prepare to deal and plan for these risks, including sensitivity analysis, scenario analysis, and break-even analysis among others.<\/li>\r\n<\/ul>\r\n<h4>Key Terms<\/h4>\r\n<ul>\r\n \t<li><strong>capital budgeting<\/strong>: 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.<\/li>\r\n \t<li><strong>risk<\/strong>: The potential that a chosen action or activity (including the choice of inaction) will lead to a loss (an undesirable outcome).<\/li>\r\n<\/ul>\r\n<\/div>\r\n<h3>Capital Budgeting<\/h3>\r\nCapital budgeting (or investment appraisal) is 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. When taking on this planning process, managers must take into account the potential risks of the investment not panning out the way they plan for it to, for any number of reasons. In order to discuss this further, we should look into defining the concept or risk.\r\n<h3>Risk<\/h3>\r\nRisk is the potential that a chosen action or activity (including the choice of inaction) will lead to a loss (an undesirable outcome). The notion implies that a choice having an influence on the outcome exists (or existed). Potential losses themselves may also be called \"risks. \"\r\n<div class=\"wp-caption aligncenter\" data-global-id=\"gid:\/\/boundless\/Image\/24198\">\r\n<div class=\"figure-cont\">\r\n\r\n[caption id=\"\" align=\"aligncenter\" width=\"612\"]<img src=\"https:\/\/pressbooks.ccconline.org\/ppscacc2010principlesoffinance\/wp-content\/uploads\/sites\/128\/2023\/03\/possible-risks1.png\" alt=\"This chart represents a list of the possible risks involved in running an organic business.\" width=\"612\" height=\"906\" \/> <strong>Possible Business Risks:<\/strong> 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.[\/caption]\r\n\r\n<\/div>\r\n<\/div>\r\n<\/div>\r\n<\/div>\r\n<\/div>\r\n<\/div>\r\n&nbsp;\r\n\r\n<span style=\"font-size: 1em;text-align: initial\">There are numerous kinds of risks to be taken into account when considering capital budgeting including:<\/span>\r\n<div id=\"block_app\">\r\n<div class=\"articleBody\">\r\n<div class=\"articleContent\">\r\n<div class=\"boundless-concept\">\r\n<ul>\r\n \t<li>corporate risk<\/li>\r\n \t<li>international risk (including currency risk)<\/li>\r\n \t<li>industry-specific risk<\/li>\r\n \t<li>market risk<\/li>\r\n \t<li>stand-alone risk<\/li>\r\n \t<li>project-specific risk<\/li>\r\n<\/ul>\r\nEach of these risks addresses an area in which some sort of volatility could forcibly alter the plan of firm managers. For example, market risk involves the risk of losses in position due to movement in market positions.\r\n\r\nThere are different ways to measure and prepare to deal with risks as well. One such way is to conduct a sensitivity analysis. Sensitivity analysis is the study of how the uncertainty in the output of a model (numerical or otherwise) can be apportioned to different sources of uncertainty in the model input.\r\n\r\nA related practice is uncertainty analysis which focuses rather on quantifying uncertainty in model output. Ideally, uncertainty and sensitivity analysis should be run in tandem. Another method is scenario analysis, which involves the process of analyzing possible future events by considering alternative possible outcomes.\r\n\r\nFor example, a financial institution might attempt to forecast several possible scenarios for the economy (e.g., rapid growth, moderate growth, slow growth), and it might also attempt to forecast financial market returns (for bonds, stocks, and cash) in each of those scenarios. It might consider sub-sets of each of the possibilities. It might further seek to determine correlations and assign probabilities to the scenarios. Then it will be in a position to consider how to distribute assets between asset types (i.e., asset allocation). The institution can also calculate the scenario-weighted expected return (which figure will indicate the overall attractiveness of the financial environment). It may also perform stress testing, using adverse scenarios.\r\n\r\n<\/div>\r\n<div class=\"boundless-concept\">\r\n<h2>Risk Aversion<\/h2>\r\nRisk aversion describes how people react to conditions of uncertainty and has implications for investment decisions.\r\n<div class=\"textbox learning-objectives\">\r\n<h3>Learning Objectives<\/h3>\r\nEvaluate a person's risk aversion\r\n\r\n<\/div>\r\n<div class=\"textbox key-takeaways\">\r\n<h3>Key Takeaways<\/h3>\r\n<h4>Key Points<\/h4>\r\n<ul>\r\n \t<li>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.<\/li>\r\n \t<li>People can be risk averse, risk neutral, or risk loving. A risk averse person will generally take a guaranteed outcome even if it has a lower expected payout than a gamble, while a risk lover will take on the gamble unless the guaranteed payoff is greater than the expected payoff of the gamble.<\/li>\r\n \t<li>Firm management can adopt different stances based on how risk averse they feel they should be, given different market qualities and firm conditions. They will make capital investments that they feel will have the best payoffs, given the risks involved.<\/li>\r\n<\/ul>\r\n<h4>Key Terms<\/h4>\r\n<ul>\r\n \t<li><strong>Risk Aversion<\/strong>: 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.<\/li>\r\n<\/ul>\r\n<\/div>\r\nIn the realm of finance and economics, Risk Aversion is a concept that addresses how people will react to a situation with uncertain outcomes.\r\n\r\n<span style=\"text-align: initial;color: #333333;font-size: 1em\">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. For example, a risk-averse investor might choose to put his or her money into a bank account with a low but guaranteed interest rate instead of investing in a stock that may have high expected returns, but also involves a chance of losing value. Risk aversion can be applied to many different situations, including investments, lotteries, and other situations with uncertain outcomes. Because organizations are composed of individuals, risk aversion at the individual level plays a role in organizational decision making.<\/span>\r\n\r\n<span style=\"text-align: initial;color: #333333;font-size: 1em\"><span style=\"text-align: initial;font-size: 1em\">People fall under different categories of risk aversion. If we look at an example where a person could receive 50 dollars without risk, or take a gamble where they receive 100 dollars or 0 dollars depending on the outcome of a coin flip, we can explain the differences. We see when we use the expected payoffs of each scenario we see that each has an expected payoff of 50 dollars. Situation one has a 100% chance of getting 50 dollars so it's expected payoff is (1)(50)=50. For the second situation, the expected payoff deals with a 50-50 chance of getting 100 or 0 dollars so, (.5)(100)+(.5)(0)=50. This is important to know for this example. A risk-averse, or risk avoiding person would take the guaranteed payment of 50, or even less than that (40 or 30) depending on how risk averse they are. A risk neutral person would be indifferent between taking the gamble or the guaranteed money. Finally a risk loving person would take the non-guaranteed chance of possibly winning 100 dollars, rather than settling for the guaranteed option. If the guaranteed option was greater than 50 dollars, then the risk lover might consider the possibility of taking it.<\/span><\/span>\r\n<div class=\"wp-caption alignright\" data-global-id=\"gid:\/\/boundless\/Image\/31048\">\r\n<div class=\"figure-cont\">\r\n\r\n[caption id=\"\" align=\"alignright\" width=\"305\"]<img class=\"\" src=\"https:\/\/pressbooks.ccconline.org\/ppscacc2010principlesoffinance\/wp-content\/uploads\/sites\/128\/2023\/03\/gambling-chips2.jpeg\" alt=\"Image of stacked poker chips. \" width=\"305\" height=\"203\" \/> <strong>High dividend gambles<\/strong>: Risk aversion can be applied to many different situations including investments, lotteries, and any other situations with uncertain outcomes.[\/caption]\r\n\r\n&nbsp;\r\n\r\n<\/div>\r\n<\/div>\r\nThis can be extended to capital budgeting. A firm's management can adopt different stances based on how risk averse they feel they should be, given different market qualities and firm conditions. They will make capital investments that they feel will have the best payoffs, given the risks involved, and if they take a more risk averse stance they will make capital investment decisions that have a more guaranteed payoff. On the other hand, if they be more risk loving, they will be attracted to the more risky investments for capital that they believe have a chance for higher payoff.\r\n\r\n<\/div>\r\n<div class=\"boundless-concept\">\r\n<h2>Approaches to Assessing Risk<\/h2>\r\nSome of the quantitative definitions of risk are grounded in statistical theory and lead naturally to statistical estimates, but some are more subjective.\r\n<div class=\"textbox learning-objectives\">\r\n<h3>Learning Objectives<\/h3>\r\nDefine different types of risk\r\n\r\n<\/div>\r\n<div class=\"textbox key-takeaways\">\r\n<h3>Key Takeaways<\/h3>\r\n<h4>Key Points<\/h4>\r\n<ul>\r\n \t<li>As risk carries so many different meanings, there are many formal methods used to assess or to \"measure\" risk. Planned actions are subject to large cost and benefit risks, so proper risk assessment and management is crucial to making them successful.<\/li>\r\n \t<li>The assessment of risk is an integral part of risk management in general, and includes probability studies, impact of events, taking into account the affect of every known risk on the project, and the actions needed to resolve these issues, should they occur.<\/li>\r\n \t<li>Behavioral finance focuses on risk-aversion, and other ways that financial behavior varies from what analysts call rational. Here, risk is uncertainty associated with return on assets. In enterprise risk management, risk is an event that can have negative influences on the enterprise in question.<\/li>\r\n<\/ul>\r\n<h4>Key Terms<\/h4>\r\n<ul>\r\n \t<li><strong>Behavioral Finance<\/strong>: Field that focuses on human risk-aversion, asymmetric regret, and other ways that human financial behavior varies from what analysts call \"rational\".<\/li>\r\n \t<li><strong>risk<\/strong>: The potential that a chosen action or activity (including the choice of inaction) will lead to a loss (an undesirable outcome).<\/li>\r\n<\/ul>\r\n<\/div>\r\nThere are numerous important and applicable approaches to assessing risk in capital budgeting.\r\n\r\nSince planned actions are subject to large cost and benefit risks, proper risk assessment and risk management for such actions are crucial to making them successful. As risk carries so many different meanings, there are many formal methods used to assess or to \"measure\" risk. Some of the quantitative definitions of risk are well-grounded in statistics theory and lead naturally to statistical estimates, but some are more subjective. For example, in many cases a critical factor is human decision making. One can say that in the realm of capital budgeting and corporate finance, both types of risk assessment are crucial.\r\n<div class=\"wp-caption alignleft\" data-global-id=\"gid:\/\/boundless\/Image\/14059\">\r\n<div class=\"figure-cont\">\r\n\r\n[caption id=\"\" align=\"alignleft\" width=\"459\"]<img src=\"https:\/\/pressbooks.ccconline.org\/ppscacc2010principlesoffinance\/wp-content\/uploads\/sites\/128\/2023\/03\/6234166253-7a8ee6cd74-z3.jpeg\" alt=\"Image of workers inspecting equipment. \" width=\"459\" height=\"364\" \/> <strong>Inspecting Equipment<\/strong>: Risk can be assessed in a number of ways, and is a critical step in capital budgeting and planning, as well as project management[\/caption]\r\n<p class=\"wp-caption-text\"><\/p>\r\n\r\n<\/div>\r\n<\/div>\r\nThe field of behavioral finance focuses on human risk-aversion, asymmetric regret, and other ways that human financial behavior varies from what analysts call \"rational\". Risk, in that case, is the degree of uncertainty associated with a return on an asset. In enterprise risk management, a risk is defined as a possible event or circumstance that can have negative influences on the enterprise in question. Its impact can be on the very existence, the resources (human and capital), the products and services, or the customers of the enterprise, as well as external impacts on society, markets, or the environment. In a financial institution, enterprise risk management is normally thought of as the combination of credit risk, interest rate risk or asset liability management, market risk, and operational risk.\r\n\r\nIn project management, risk management can include: planning how risk will be managed, assigning a risk officer, maintaining a database of live risks, and preparing risk mitigation plans. The assessment of risk is an integral part of risk management in general, and includes probability studies, impact of events, and takes into account the affect of every known risk on the project, and the actions needed to resolve these issues, should they occur.\r\n\r\nIn the more general case, every probable risk can have a pre-formulated plan to deal with its possible consequences. From the average cost per employee over time, or cost accrual ratio, a project manager can estimate: the cost associated with the risk, if it arises, estimated by multiplying employee costs per unit time by the estimated time lost (cost impact, C where C = cost accrual ratio * S), the probable increase in time associated with a risk (schedule variance due to risk, Rs where Rs = Probability * S). Sorting on this value puts the highest risks to the schedule first. This is intended to cause the greatest risks to the project to be attempted first so that risk is minimized as quickly as possible.This can be slightly misleading as schedule variances with a large P (probability) and small S (estimated time lost) and vice versa are not equivalent. (The risk of the RMS Titanic sinking vs. the passengers' meals being served at slightly the wrong time).\r\n\r\nThe probable increase in cost associated with a risk (cost variance due to risk, Rc where Rc = P*C = P*Cost Accrual Ratio*S = P*S*CAR): sorting on this value puts the highest risks to the budget first, which can raise concerns about schedule variance.\r\n\r\n<\/div>\r\n<h4 class=\"licensing-label\">Licenses and Attributions<\/h4>\r\n<div class=\"licensing collapsed\">\r\n<h4>CC licensed content, Shared previously<\/h4>\r\n<ul>\r\n \t<li>Curation and Revision. <strong>Provided by<\/strong>: Boundless.com. <strong>License<\/strong>: <em><a href=\"https:\/\/creativecommons.org\/licenses\/by-sa\/4.0\/\" target=\"_blank\" rel=\"license nofollow noopener\">CC BY-SA: Attribution-ShareAlike<\/a><\/em><\/li>\r\n<\/ul>\r\n<h4>CC licensed content, Specific attribution<\/h4>\r\n<ul>\r\n \t<li>Sensitivity analysis. <strong>Provided by<\/strong>: Wikipedia. <strong>Located at<\/strong>: <a href=\"https:\/\/en.wikipedia.org\/wiki\/Sensitivity_analysis\" target=\"_blank\" rel=\"license noindex nofollow noopener\">https:\/\/en.wikipedia.org\/wiki\/Sensitivity_analysis<\/a>. <strong>License<\/strong>: <em><a href=\"https:\/\/creativecommons.org\/licenses\/by-sa\/4.0\/\" target=\"_blank\" rel=\"license nofollow noopener\">CC BY-SA: Attribution-ShareAlike<\/a><\/em><\/li>\r\n \t<li>Scenario analysis. <strong>Provided by<\/strong>: Wikipedia. <strong>License<\/strong>: <em><a href=\"https:\/\/creativecommons.org\/licenses\/by-sa\/4.0\/\" target=\"_blank\" rel=\"license nofollow noopener\">CC BY-SA: Attribution-ShareAlike<\/a><\/em><\/li>\r\n \t<li>Risk. <strong>Provided by<\/strong>: Wikipedia. <strong>License<\/strong>: <em><a href=\"https:\/\/creativecommons.org\/licenses\/by-sa\/4.0\/\" target=\"_blank\" rel=\"license nofollow noopener\">CC BY-SA: Attribution-ShareAlike<\/a><\/em><\/li>\r\n \t<li>Capital budgeting. <strong>Provided by<\/strong>: Wikipedia. <strong>License<\/strong>: <em><a href=\"https:\/\/creativecommons.org\/licenses\/by-sa\/4.0\/\" target=\"_blank\" rel=\"license nofollow noopener\">CC BY-SA: Attribution-ShareAlike<\/a><\/em><\/li>\r\n \t<li>Scenario analysis. <strong>Provided by<\/strong>: Wikipedia. <strong>License<\/strong>: <em><a href=\"https:\/\/creativecommons.org\/licenses\/by-sa\/4.0\/\" target=\"_blank\" rel=\"license nofollow noopener\">CC BY-SA: Attribution-ShareAlike<\/a><\/em><\/li>\r\n \t<li>risk. <strong>Provided by<\/strong>: Wiktionary. <strong>License<\/strong>: <em><a href=\"https:\/\/creativecommons.org\/licenses\/by-sa\/4.0\/\" target=\"_blank\" rel=\"license nofollow noopener\">CC BY-SA: Attribution-ShareAlike<\/a><\/em><\/li>\r\n \t<li>capital budgeting. <strong>Provided by<\/strong>: Wikipedia. <strong>License<\/strong>: <em><a href=\"https:\/\/creativecommons.org\/licenses\/by-sa\/4.0\/\" target=\"_blank\" rel=\"license nofollow noopener\">CC BY-SA: Attribution-ShareAlike<\/a><\/em><\/li>\r\n \t<li>Possible-risks. <strong>Provided by<\/strong>: Wikimedia. <strong>License<\/strong>: <em><a href=\"https:\/\/creativecommons.org\/licenses\/by-sa\/4.0\/\" target=\"_blank\" rel=\"license nofollow noopener\">CC BY-SA: Attribution-ShareAlike<\/a><\/em><\/li>\r\n \t<li>Risk aversion. <strong>Provided by<\/strong>: Wikipedia. <strong>License<\/strong>: <em><a href=\"https:\/\/creativecommons.org\/licenses\/by-sa\/4.0\/\" target=\"_blank\" rel=\"license nofollow noopener\">CC BY-SA: Attribution-ShareAlike<\/a><\/em><\/li>\r\n \t<li>Risk Aversion. <strong>Provided by<\/strong>: Wikipedia. <strong>License<\/strong>: <em><a href=\"https:\/\/creativecommons.org\/licenses\/by-sa\/4.0\/\" target=\"_blank\" rel=\"license nofollow noopener\">CC BY-SA: Attribution-ShareAlike<\/a><\/em><\/li>\r\n \t<li>Possible-risks. <strong>Provided by<\/strong>: Wikimedia. <strong>License<\/strong>: <em><a href=\"https:\/\/creativecommons.org\/licenses\/by-sa\/4.0\/\" target=\"_blank\" rel=\"license nofollow noopener\">CC BY-SA: Attribution-ShareAlike<\/a><\/em><\/li>\r\n \t<li>Wikimedia. <strong>Provided by<\/strong>: Wikimedia. <strong>License<\/strong>: <em><a href=\"https:\/\/creativecommons.org\/licenses\/by-sa\/4.0\/\" target=\"_blank\" rel=\"license nofollow noopener\">CC BY-SA: Attribution-ShareAlike<\/a><\/em><\/li>\r\n \t<li>Risk management. <strong>Provided by<\/strong>: Wikipedia. <strong>License<\/strong>: <em><a href=\"https:\/\/creativecommons.org\/licenses\/by-sa\/4.0\/\" target=\"_blank\" rel=\"license nofollow noopener\">CC BY-SA: Attribution-ShareAlike<\/a><\/em><\/li>\r\n \t<li>Risk assessment. <strong>Provided by<\/strong>: Wikipedia. <strong>License<\/strong>: <em><a href=\"https:\/\/creativecommons.org\/licenses\/by-sa\/4.0\/\" target=\"_blank\" rel=\"license nofollow noopener\">CC BY-SA: Attribution-ShareAlike<\/a><\/em><\/li>\r\n \t<li>Risk. <strong>Provided by<\/strong>: Wikipedia. <strong>License<\/strong>: <em><a href=\"https:\/\/creativecommons.org\/licenses\/by-sa\/4.0\/\" target=\"_blank\" rel=\"license nofollow noopener\">CC BY-SA: Attribution-ShareAlike<\/a><\/em><\/li>\r\n \t<li>Behavioral Finance. <strong>Provided by<\/strong>: Wikipedia. <strong>License<\/strong>: <em><a href=\"https:\/\/creativecommons.org\/licenses\/by-sa\/4.0\/\" target=\"_blank\" rel=\"license nofollow noopener\">CC BY-SA: Attribution-ShareAlike<\/a><\/em><\/li>\r\n \t<li>risk. <strong>Provided by<\/strong>: Wiktionary. <strong>License<\/strong>: <em><a href=\"https:\/\/creativecommons.org\/licenses\/by-sa\/4.0\/\" target=\"_blank\" rel=\"license nofollow noopener\">CC BY-SA: Attribution-ShareAlike<\/a><\/em><\/li>\r\n \t<li>Possible-risks. <strong>Provided by<\/strong>: Wikimedia. <strong>License<\/strong>: <em><a href=\"https:\/\/creativecommons.org\/licenses\/by-sa\/4.0\/\" target=\"_blank\" rel=\"license nofollow noopener\">CC BY-SA: Attribution-ShareAlike<\/a><\/em><\/li>\r\n \t<li>Wikimedia. <strong>Provided by<\/strong>: Wikimedia. <strong>License<\/strong>: <em><a href=\"https:\/\/creativecommons.org\/licenses\/by-sa\/4.0\/\" target=\"_blank\" rel=\"license nofollow noopener\">CC BY-SA: Attribution-ShareAlike<\/a><\/em><\/li>\r\n \t<li>All sizes | Trevallyn assessment | Flickr - Photo Sharing!. <strong>Provided by<\/strong>: Flickr. <strong>Located at<\/strong>: <a href=\"https:\/\/www.flickr.com\/photos\/hydropower\/6234166253\/sizes\/z\/in\/photostream\/\" target=\"_blank\" rel=\"license noindex nofollow noopener\">https:\/\/www.flickr.com\/photos\/hydropower\/6234166253\/sizes\/z\/in\/photostream\/<\/a>. <strong>License<\/strong>: <em><a href=\"https:\/\/creativecommons.org\/licenses\/by\/4.0\/\" target=\"_blank\" rel=\"license nofollow noopener\">CC BY: Attribution<\/a>\u00a0<\/em><\/li>\r\n<\/ul>\r\n<\/div>\r\n<\/div>\r\n<\/div>\r\n<\/div>","rendered":"<div id=\"block_ssi-global_HeaderFragment\" class=\"\">\n<header class=\"gh-flex gh-justify-between gh-items-center gh-bg-white gh-py-4 gh-shadow gh-z-[1299] gh-px-16 gh-relative\">\n<div class=\"gh-flex gh-flex-1 gh-items-center\"><\/div>\n<\/header>\n<\/div>\n<div id=\"block_app\">\n<div class=\"articleBody\">\n<h2>Risks Involved in Capital Budgeting<\/h2>\n<div class=\"articleContent\">\n<div class=\"boundless-concept\">\n<p>The process of capital budgeting must take into account the different risks faced by corporations and their managers.<\/p>\n<div class=\"textbox learning-objectives\">\n<h3>Learning Objectives<\/h3>\n<p>Identify the different risks that must be accounted for in the capital budgeting process<\/p>\n<\/div>\n<div class=\"textbox key-takeaways\">\n<h3>Key Takeaways<\/h3>\n<h4>Key Points<\/h4>\n<ul>\n<li>Capital budgeting (or investment appraisal) is the planning process used to determine whether an organization&#8217;s long-term investments are worth pursuing. The risk that can arise here involves the potential that a chosen action or activity (including the choice of inaction) will lead to a loss.<\/li>\n<li>There are numerous kinds of risks to be taken into account when considering capital budgeting. Each of these risks addresses an area in which some sort of volatility could forcibly alter the plan of firm managers.<\/li>\n<li>There are different ways to measure and prepare to deal and plan for these risks, including sensitivity analysis, scenario analysis, and break-even analysis among others.<\/li>\n<\/ul>\n<h4>Key Terms<\/h4>\n<ul>\n<li><strong>capital budgeting<\/strong>: The planning process used to determine whether an organization&#8217;s long term investments, such as new machinery, replacement machinery, new plants, new products, and research development projects are worth pursuing.<\/li>\n<li><strong>risk<\/strong>: The potential that a chosen action or activity (including the choice of inaction) will lead to a loss (an undesirable outcome).<\/li>\n<\/ul>\n<\/div>\n<h3>Capital Budgeting<\/h3>\n<p>Capital budgeting (or investment appraisal) is the planning process used to determine whether an organization&#8217;s long term investments, such as new machinery, replacement machinery, new plants, new products, and research development projects are worth pursuing. When taking on this planning process, managers must take into account the potential risks of the investment not panning out the way they plan for it to, for any number of reasons. In order to discuss this further, we should look into defining the concept or risk.<\/p>\n<h3>Risk<\/h3>\n<p>Risk is the potential that a chosen action or activity (including the choice of inaction) will lead to a loss (an undesirable outcome). The notion implies that a choice having an influence on the outcome exists (or existed). Potential losses themselves may also be called &#8220;risks. &#8221;<\/p>\n<div class=\"wp-caption aligncenter\" data-global-id=\"gid:\/\/boundless\/Image\/24198\">\n<div class=\"figure-cont\">\n<figure style=\"width: 612px\" class=\"wp-caption aligncenter\"><img loading=\"lazy\" decoding=\"async\" src=\"https:\/\/pressbooks.ccconline.org\/ppscacc2010principlesoffinance\/wp-content\/uploads\/sites\/128\/2023\/03\/possible-risks1.png\" alt=\"This chart represents a list of the possible risks involved in running an organic business.\" width=\"612\" height=\"906\" \/><figcaption class=\"wp-caption-text\"><strong>Possible Business Risks:<\/strong> 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.<\/figcaption><\/figure>\n<\/div>\n<\/div>\n<\/div>\n<\/div>\n<\/div>\n<\/div>\n<p>&nbsp;<\/p>\n<p><span style=\"font-size: 1em;text-align: initial\">There are numerous kinds of risks to be taken into account when considering capital budgeting including:<\/span><\/p>\n<div>\n<div class=\"articleBody\">\n<div class=\"articleContent\">\n<div class=\"boundless-concept\">\n<ul>\n<li>corporate risk<\/li>\n<li>international risk (including currency risk)<\/li>\n<li>industry-specific risk<\/li>\n<li>market risk<\/li>\n<li>stand-alone risk<\/li>\n<li>project-specific risk<\/li>\n<\/ul>\n<p>Each of these risks addresses an area in which some sort of volatility could forcibly alter the plan of firm managers. For example, market risk involves the risk of losses in position due to movement in market positions.<\/p>\n<p>There are different ways to measure and prepare to deal with risks as well. One such way is to conduct a sensitivity analysis. Sensitivity analysis is the study of how the uncertainty in the output of a model (numerical or otherwise) can be apportioned to different sources of uncertainty in the model input.<\/p>\n<p>A related practice is uncertainty analysis which focuses rather on quantifying uncertainty in model output. Ideally, uncertainty and sensitivity analysis should be run in tandem. Another method is scenario analysis, which involves the process of analyzing possible future events by considering alternative possible outcomes.<\/p>\n<p>For example, a financial institution might attempt to forecast several possible scenarios for the economy (e.g., rapid growth, moderate growth, slow growth), and it might also attempt to forecast financial market returns (for bonds, stocks, and cash) in each of those scenarios. It might consider sub-sets of each of the possibilities. It might further seek to determine correlations and assign probabilities to the scenarios. Then it will be in a position to consider how to distribute assets between asset types (i.e., asset allocation). The institution can also calculate the scenario-weighted expected return (which figure will indicate the overall attractiveness of the financial environment). It may also perform stress testing, using adverse scenarios.<\/p>\n<\/div>\n<div class=\"boundless-concept\">\n<h2>Risk Aversion<\/h2>\n<p>Risk aversion describes how people react to conditions of uncertainty and has implications for investment decisions.<\/p>\n<div class=\"textbox learning-objectives\">\n<h3>Learning Objectives<\/h3>\n<p>Evaluate a person&#8217;s risk aversion<\/p>\n<\/div>\n<div class=\"textbox key-takeaways\">\n<h3>Key Takeaways<\/h3>\n<h4>Key Points<\/h4>\n<ul>\n<li>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.<\/li>\n<li>People can be risk averse, risk neutral, or risk loving. A risk averse person will generally take a guaranteed outcome even if it has a lower expected payout than a gamble, while a risk lover will take on the gamble unless the guaranteed payoff is greater than the expected payoff of the gamble.<\/li>\n<li>Firm management can adopt different stances based on how risk averse they feel they should be, given different market qualities and firm conditions. They will make capital investments that they feel will have the best payoffs, given the risks involved.<\/li>\n<\/ul>\n<h4>Key Terms<\/h4>\n<ul>\n<li><strong>Risk Aversion<\/strong>: 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.<\/li>\n<\/ul>\n<\/div>\n<p>In the realm of finance and economics, Risk Aversion is a concept that addresses how people will react to a situation with uncertain outcomes.<\/p>\n<p><span style=\"text-align: initial;color: #333333;font-size: 1em\">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. For example, a risk-averse investor might choose to put his or her money into a bank account with a low but guaranteed interest rate instead of investing in a stock that may have high expected returns, but also involves a chance of losing value. Risk aversion can be applied to many different situations, including investments, lotteries, and other situations with uncertain outcomes. Because organizations are composed of individuals, risk aversion at the individual level plays a role in organizational decision making.<\/span><\/p>\n<p><span style=\"text-align: initial;color: #333333;font-size: 1em\"><span style=\"text-align: initial;font-size: 1em\">People fall under different categories of risk aversion. If we look at an example where a person could receive 50 dollars without risk, or take a gamble where they receive 100 dollars or 0 dollars depending on the outcome of a coin flip, we can explain the differences. We see when we use the expected payoffs of each scenario we see that each has an expected payoff of 50 dollars. Situation one has a 100% chance of getting 50 dollars so it&#8217;s expected payoff is (1)(50)=50. For the second situation, the expected payoff deals with a 50-50 chance of getting 100 or 0 dollars so, (.5)(100)+(.5)(0)=50. This is important to know for this example. A risk-averse, or risk avoiding person would take the guaranteed payment of 50, or even less than that (40 or 30) depending on how risk averse they are. A risk neutral person would be indifferent between taking the gamble or the guaranteed money. Finally a risk loving person would take the non-guaranteed chance of possibly winning 100 dollars, rather than settling for the guaranteed option. If the guaranteed option was greater than 50 dollars, then the risk lover might consider the possibility of taking it.<\/span><\/span><\/p>\n<div class=\"wp-caption alignright\" data-global-id=\"gid:\/\/boundless\/Image\/31048\">\n<div class=\"figure-cont\">\n<figure style=\"width: 305px\" class=\"wp-caption alignright\"><img loading=\"lazy\" decoding=\"async\" class=\"\" src=\"https:\/\/pressbooks.ccconline.org\/ppscacc2010principlesoffinance\/wp-content\/uploads\/sites\/128\/2023\/03\/gambling-chips2.jpeg\" alt=\"Image of stacked poker chips.\" width=\"305\" height=\"203\" \/><figcaption class=\"wp-caption-text\"><strong>High dividend gambles<\/strong>: Risk aversion can be applied to many different situations including investments, lotteries, and any other situations with uncertain outcomes.<\/figcaption><\/figure>\n<p>&nbsp;<\/p>\n<\/div>\n<\/div>\n<p>This can be extended to capital budgeting. A firm&#8217;s management can adopt different stances based on how risk averse they feel they should be, given different market qualities and firm conditions. They will make capital investments that they feel will have the best payoffs, given the risks involved, and if they take a more risk averse stance they will make capital investment decisions that have a more guaranteed payoff. On the other hand, if they be more risk loving, they will be attracted to the more risky investments for capital that they believe have a chance for higher payoff.<\/p>\n<\/div>\n<div class=\"boundless-concept\">\n<h2>Approaches to Assessing Risk<\/h2>\n<p>Some of the quantitative definitions of risk are grounded in statistical theory and lead naturally to statistical estimates, but some are more subjective.<\/p>\n<div class=\"textbox learning-objectives\">\n<h3>Learning Objectives<\/h3>\n<p>Define different types of risk<\/p>\n<\/div>\n<div class=\"textbox key-takeaways\">\n<h3>Key Takeaways<\/h3>\n<h4>Key Points<\/h4>\n<ul>\n<li>As risk carries so many different meanings, there are many formal methods used to assess or to &#8220;measure&#8221; risk. Planned actions are subject to large cost and benefit risks, so proper risk assessment and management is crucial to making them successful.<\/li>\n<li>The assessment of risk is an integral part of risk management in general, and includes probability studies, impact of events, taking into account the affect of every known risk on the project, and the actions needed to resolve these issues, should they occur.<\/li>\n<li>Behavioral finance focuses on risk-aversion, and other ways that financial behavior varies from what analysts call rational. Here, risk is uncertainty associated with return on assets. In enterprise risk management, risk is an event that can have negative influences on the enterprise in question.<\/li>\n<\/ul>\n<h4>Key Terms<\/h4>\n<ul>\n<li><strong>Behavioral Finance<\/strong>: Field that focuses on human risk-aversion, asymmetric regret, and other ways that human financial behavior varies from what analysts call &#8220;rational&#8221;.<\/li>\n<li><strong>risk<\/strong>: The potential that a chosen action or activity (including the choice of inaction) will lead to a loss (an undesirable outcome).<\/li>\n<\/ul>\n<\/div>\n<p>There are numerous important and applicable approaches to assessing risk in capital budgeting.<\/p>\n<p>Since planned actions are subject to large cost and benefit risks, proper risk assessment and risk management for such actions are crucial to making them successful. As risk carries so many different meanings, there are many formal methods used to assess or to &#8220;measure&#8221; risk. Some of the quantitative definitions of risk are well-grounded in statistics theory and lead naturally to statistical estimates, but some are more subjective. For example, in many cases a critical factor is human decision making. One can say that in the realm of capital budgeting and corporate finance, both types of risk assessment are crucial.<\/p>\n<div class=\"wp-caption alignleft\" data-global-id=\"gid:\/\/boundless\/Image\/14059\">\n<div class=\"figure-cont\">\n<figure style=\"width: 459px\" class=\"wp-caption alignleft\"><img loading=\"lazy\" decoding=\"async\" src=\"https:\/\/pressbooks.ccconline.org\/ppscacc2010principlesoffinance\/wp-content\/uploads\/sites\/128\/2023\/03\/6234166253-7a8ee6cd74-z3.jpeg\" alt=\"Image of workers inspecting equipment.\" width=\"459\" height=\"364\" \/><figcaption class=\"wp-caption-text\"><strong>Inspecting Equipment<\/strong>: Risk can be assessed in a number of ways, and is a critical step in capital budgeting and planning, as well as project management<\/figcaption><\/figure>\n<p class=\"wp-caption-text\">\n<\/div>\n<\/div>\n<p>The field of behavioral finance focuses on human risk-aversion, asymmetric regret, and other ways that human financial behavior varies from what analysts call &#8220;rational&#8221;. Risk, in that case, is the degree of uncertainty associated with a return on an asset. In enterprise risk management, a risk is defined as a possible event or circumstance that can have negative influences on the enterprise in question. Its impact can be on the very existence, the resources (human and capital), the products and services, or the customers of the enterprise, as well as external impacts on society, markets, or the environment. In a financial institution, enterprise risk management is normally thought of as the combination of credit risk, interest rate risk or asset liability management, market risk, and operational risk.<\/p>\n<p>In project management, risk management can include: planning how risk will be managed, assigning a risk officer, maintaining a database of live risks, and preparing risk mitigation plans. The assessment of risk is an integral part of risk management in general, and includes probability studies, impact of events, and takes into account the affect of every known risk on the project, and the actions needed to resolve these issues, should they occur.<\/p>\n<p>In the more general case, every probable risk can have a pre-formulated plan to deal with its possible consequences. From the average cost per employee over time, or cost accrual ratio, a project manager can estimate: the cost associated with the risk, if it arises, estimated by multiplying employee costs per unit time by the estimated time lost (cost impact, C where C = cost accrual ratio * S), the probable increase in time associated with a risk (schedule variance due to risk, Rs where Rs = Probability * S). Sorting on this value puts the highest risks to the schedule first. This is intended to cause the greatest risks to the project to be attempted first so that risk is minimized as quickly as possible.This can be slightly misleading as schedule variances with a large P (probability) and small S (estimated time lost) and vice versa are not equivalent. (The risk of the RMS Titanic sinking vs. the passengers&#8217; meals being served at slightly the wrong time).<\/p>\n<p>The probable increase in cost associated with a risk (cost variance due to risk, Rc where Rc = P*C = P*Cost Accrual Ratio*S = P*S*CAR): sorting on this value puts the highest risks to the budget first, which can raise concerns about schedule variance.<\/p>\n<\/div>\n<h4 class=\"licensing-label\">Licenses and Attributions<\/h4>\n<div class=\"licensing collapsed\">\n<h4>CC licensed content, Shared previously<\/h4>\n<ul>\n<li>Curation and Revision. <strong>Provided by<\/strong>: Boundless.com. <strong>License<\/strong>: <em><a href=\"https:\/\/creativecommons.org\/licenses\/by-sa\/4.0\/\" target=\"_blank\" rel=\"license nofollow noopener\">CC BY-SA: Attribution-ShareAlike<\/a><\/em><\/li>\n<\/ul>\n<h4>CC licensed content, Specific attribution<\/h4>\n<ul>\n<li>Sensitivity analysis. <strong>Provided by<\/strong>: Wikipedia. <strong>Located at<\/strong>: <a href=\"https:\/\/en.wikipedia.org\/wiki\/Sensitivity_analysis\" target=\"_blank\" rel=\"license noindex nofollow noopener\">https:\/\/en.wikipedia.org\/wiki\/Sensitivity_analysis<\/a>. <strong>License<\/strong>: <em><a href=\"https:\/\/creativecommons.org\/licenses\/by-sa\/4.0\/\" target=\"_blank\" rel=\"license nofollow noopener\">CC BY-SA: Attribution-ShareAlike<\/a><\/em><\/li>\n<li>Scenario analysis. <strong>Provided by<\/strong>: Wikipedia. <strong>License<\/strong>: <em><a href=\"https:\/\/creativecommons.org\/licenses\/by-sa\/4.0\/\" target=\"_blank\" rel=\"license nofollow noopener\">CC BY-SA: Attribution-ShareAlike<\/a><\/em><\/li>\n<li>Risk. <strong>Provided by<\/strong>: Wikipedia. <strong>License<\/strong>: <em><a href=\"https:\/\/creativecommons.org\/licenses\/by-sa\/4.0\/\" target=\"_blank\" rel=\"license nofollow noopener\">CC BY-SA: Attribution-ShareAlike<\/a><\/em><\/li>\n<li>Capital budgeting. <strong>Provided by<\/strong>: Wikipedia. <strong>License<\/strong>: <em><a href=\"https:\/\/creativecommons.org\/licenses\/by-sa\/4.0\/\" target=\"_blank\" rel=\"license nofollow noopener\">CC BY-SA: Attribution-ShareAlike<\/a><\/em><\/li>\n<li>Scenario analysis. <strong>Provided by<\/strong>: Wikipedia. <strong>License<\/strong>: <em><a href=\"https:\/\/creativecommons.org\/licenses\/by-sa\/4.0\/\" target=\"_blank\" rel=\"license nofollow noopener\">CC BY-SA: Attribution-ShareAlike<\/a><\/em><\/li>\n<li>risk. <strong>Provided by<\/strong>: Wiktionary. <strong>License<\/strong>: <em><a href=\"https:\/\/creativecommons.org\/licenses\/by-sa\/4.0\/\" target=\"_blank\" rel=\"license nofollow noopener\">CC BY-SA: Attribution-ShareAlike<\/a><\/em><\/li>\n<li>capital budgeting. <strong>Provided by<\/strong>: Wikipedia. <strong>License<\/strong>: <em><a href=\"https:\/\/creativecommons.org\/licenses\/by-sa\/4.0\/\" target=\"_blank\" rel=\"license nofollow noopener\">CC BY-SA: Attribution-ShareAlike<\/a><\/em><\/li>\n<li>Possible-risks. <strong>Provided by<\/strong>: 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Attribution-ShareAlike<\/a><\/em><\/li>\n<li>Wikimedia. <strong>Provided by<\/strong>: Wikimedia. <strong>License<\/strong>: <em><a href=\"https:\/\/creativecommons.org\/licenses\/by-sa\/4.0\/\" target=\"_blank\" rel=\"license nofollow noopener\">CC BY-SA: Attribution-ShareAlike<\/a><\/em><\/li>\n<li>Risk management. <strong>Provided by<\/strong>: Wikipedia. <strong>License<\/strong>: <em><a href=\"https:\/\/creativecommons.org\/licenses\/by-sa\/4.0\/\" target=\"_blank\" rel=\"license nofollow noopener\">CC BY-SA: Attribution-ShareAlike<\/a><\/em><\/li>\n<li>Risk assessment. <strong>Provided by<\/strong>: Wikipedia. <strong>License<\/strong>: <em><a href=\"https:\/\/creativecommons.org\/licenses\/by-sa\/4.0\/\" target=\"_blank\" rel=\"license nofollow noopener\">CC BY-SA: Attribution-ShareAlike<\/a><\/em><\/li>\n<li>Risk. <strong>Provided by<\/strong>: Wikipedia. <strong>License<\/strong>: <em><a href=\"https:\/\/creativecommons.org\/licenses\/by-sa\/4.0\/\" target=\"_blank\" rel=\"license nofollow noopener\">CC BY-SA: Attribution-ShareAlike<\/a><\/em><\/li>\n<li>Behavioral Finance. <strong>Provided by<\/strong>: Wikipedia. <strong>License<\/strong>: <em><a href=\"https:\/\/creativecommons.org\/licenses\/by-sa\/4.0\/\" target=\"_blank\" rel=\"license nofollow noopener\">CC BY-SA: Attribution-ShareAlike<\/a><\/em><\/li>\n<li>risk. <strong>Provided by<\/strong>: Wiktionary. <strong>License<\/strong>: <em><a href=\"https:\/\/creativecommons.org\/licenses\/by-sa\/4.0\/\" target=\"_blank\" rel=\"license nofollow noopener\">CC BY-SA: Attribution-ShareAlike<\/a><\/em><\/li>\n<li>Possible-risks. <strong>Provided by<\/strong>: Wikimedia. <strong>License<\/strong>: <em><a href=\"https:\/\/creativecommons.org\/licenses\/by-sa\/4.0\/\" target=\"_blank\" rel=\"license nofollow noopener\">CC BY-SA: Attribution-ShareAlike<\/a><\/em><\/li>\n<li>Wikimedia. <strong>Provided by<\/strong>: Wikimedia. <strong>License<\/strong>: <em><a 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Attribution<\/a>\u00a0<\/em><\/li>\n<\/ul>\n<\/div>\n<\/div>\n<\/div>\n<\/div>\n","protected":false},"author":101,"menu_order":12,"template":"","meta":{"pb_show_title":"on","pb_short_title":"","pb_subtitle":"","pb_authors":[],"pb_section_license":""},"chapter-type":[],"contributor":[],"license":[],"class_list":["post-649","chapter","type-chapter","status-publish","hentry"],"part":40,"_links":{"self":[{"href":"https:\/\/pressbooks.ccconline.org\/ppscacc2010principlesoffinance\/wp-json\/pressbooks\/v2\/chapters\/649","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/pressbooks.ccconline.org\/ppscacc2010principlesoffinance\/wp-json\/pressbooks\/v2\/chapters"}],"about":[{"href":"https:\/\/pressbooks.ccconline.org\/ppscacc2010principlesoffinance\/wp-json\/wp\/v2\/types\/chapter"}],"author":[{"embeddable":true,"href":"https:\/\/pressbooks.ccconline.org\/ppscacc2010principlesoffinance\/wp-json\/wp\/v2\/users\/101"}],"version-history":[{"count":7,"href":"https:\/\/pressbooks.ccconline.org\/ppscacc2010principlesoffinance\/wp-json\/pressbooks\/v2\/chapters\/649\/revisions"}],"predecessor-version":[{"id":1413,"href":"https:\/\/pressbooks.ccconline.org\/ppscacc2010principlesoffinance\/wp-json\/pressbooks\/v2\/chapters\/649\/revisions\/1413"}],"part":[{"href":"https:\/\/pressbooks.ccconline.org\/ppscacc2010principlesoffinance\/wp-json\/pressbooks\/v2\/parts\/40"}],"metadata":[{"href":"https:\/\/pressbooks.ccconline.org\/ppscacc2010principlesoffinance\/wp-json\/pressbooks\/v2\/chapters\/649\/metadata\/"}],"wp:attachment":[{"href":"https:\/\/pressbooks.ccconline.org\/ppscacc2010principlesoffinance\/wp-json\/wp\/v2\/media?parent=649"}],"wp:term":[{"taxonomy":"chapter-type","embeddable":true,"href":"https:\/\/pressbooks.ccconline.org\/ppscacc2010principlesoffinance\/wp-json\/pressbooks\/v2\/chapter-type?post=649"},{"taxonomy":"contributor","embeddable":true,"href":"https:\/\/pressbooks.ccconline.org\/ppscacc2010principlesoffinance\/wp-json\/wp\/v2\/contributor?post=649"},{"taxonomy":"license","embeddable":true,"href":"https:\/\/pressbooks.ccconline.org\/ppscacc2010principlesoffinance\/wp-json\/wp\/v2\/license?post=649"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}