15.1 a.Why is risk analysis so important to the capital budgeting process? b. De
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Question
15.1
a.Why is risk analysis so important to the capital budgeting process?
b. Describe the three types of project risk. Under what situation is each of the types most relevant to the capital budgeting decision?
c.Which type of risk is easiest to measure in practice?
d.Are the three types of project risk usually highly correlated? Explain your answer.
e.Why is the correlation among project risk measures important
15.2
a.Briefly describe sensitivity analysis.
b.What are its strengths and weaknesses?
15.3
a.Briefly describe scenario analysis.
b.What are its strengths and weaknesses?
15.4
a. Briefly describe Monte Carlo simulation.
b. What are its strengths and weaknesses?
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
15.6 What is the difference between the corporate cost of capital and a project cost of capital?
15.7 What is meant by the term capital rationing? From a purely financial standpoint, what is the optimal capital budget under capital rationing?
15.8 Santa Roberta Clinic has estimated its corporate cost of capital to be 11 percent. What are reasonable values for the project costs of capital for low-risk, average-risk, and high-risk projects?
15.9 Under what conditions should a business estimate divisional costs of capital?
15.10 Describe the qualitative approach to risk assessment. Why does this approach, which does not rely on numerical data, work?
Answer all aquestions above please !!!!!!!!
Explanation / Answer
a.Why is risk analysis so important to the capital budgeting process?
Capital budgeting process is used for the long-term investment of the organization. Risk analysis is important, as it will help determine the decision to accept or reject the project.The risk analysis that is faced by an organization include; sensitivity analysis, scenario analysis, break even analysis, hillier model, simulation analysis, decision tree analysis,and corporate risk analysis.
b. Describe the three types of project risk. Under what situation is each of the types most relevant to the capital budgeting decision?
1. Stand-Alone Risk
This risk assumes the project a company intends to pursue is a single asset that is separate from the company's other assets. It is measured by the variability of the single project alone. Stand-alone risk does not take into account how the risk of a single asset will affect the overall corporate risk.
2. Corporate Risk
This risk assumes the project a company intends to pursue is not a single asset but incorporated with a company's other assets. As such, the risk of a project could be diversified away by the company's other assets. It is measured by the potential impact a project may have on the company's earnings.
3. Market Risk
This looks at the risk of a project through the eyes of the stockholder. It looks at the project not only from a company's perspective, but from the stockholder's overall portfolio. It is measured by the effect the project may have on the company's beta.
c.Which type of risk is easiest to measure in practice?
The Market risk is easier to measure in practice because as more and more loans and previously illiquid assets become marketable and as the traditional franchises of commercial banks, insurance companies and investment banks started trading in the various securities and illiquid assets, the market value and its associated risk are easily assessed and evaluated..
Market risk management provides senior management with information on the risk exposure taken by FI traders. Management can then compare this risk exposure to the FI's capital resources. Thus, the market risk is assessible easily through the market rate prevailing for the securities.
d.Why is the correlation among project risk measures important.
Correlation is the relationship between two or more variables wherein a change in one variable induces a simultaneous change in the other. In the Monte Carlo simulation, input values for the project risk variables are randomly selected to execute the simulation runs. Therefore, if certain risk variable inputs are generated that violate the correlation between the variables, the output is likely to be off the expected value. It is therefore very important to establish the correlation between variables and then accordingly apply constraints to the simulation runs to ensure that the random selection of the inputs does not violate the defined correlation. This is done by specifying a correlation coefficient that defines the relationship between two or more variables. When the simulation rounds are performed by the computer, the specification of a correlation coefficient ensures that the relationship specified is adhered to without any violations.
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