Risk and Capital Budgeting

The main difficulty in the capital budgeting process is:

a. determining where we want to be on the risk-return scale
b. finding viable investment opportunities
c. determining the appropriate discount rate
d. maximizing shareholder value
a. determining where we want to be on the risk-return scale
Risk in capital budgeting may be defined as:

a. the chance the firm won't be able to meet its debt obligations
b. the possibility of the firm losing its competitive position
c. the variability of possible outcomes from a given investment
d. the possibility that the firm can't obtain funds needed to finance the desired asset
c. the variability of possible outcomes from a given investment
The two most important measures of risk are:

a. the variance and standard deviation
b. the expected value and standard deviation
c. the arithmetic mean and variance
d. the arithmetic mean and standard deviation
b. the expected value and standard deviation
The expected value may be defined as:

a. a weighted average of outcomes times their probability
b. the arithmetic average of the outcomes
c. the median value of the possible outcomes
d. a measure of dispersion or variability
a. a weighted average of outcomes times their probability
The standard deviation:

a. is the square root of the variance
b. measures dispersion or variability around the expected value
c. may be used to compare investments with the same expected return
d. all of the above are correct
d. all of the above are correct
All of the following are true of the coefficient of variation except:

a. it eliminates the size difficulty resulting from standard deviation
b. it is computed by dividing the standard deviation by the expected value
c. it measures the volatility of returns relative to the market
d. the larger the coefficient of variation, the greater the risk
c. it measures the volatility of returns relative to the market
All of the following are true regarding beta except:

a. it is widely used with portfolios of common stock
b. it measures the volatility of returns relative to the expected value
c. it is an important component of the Capital Asset Pricing Model (CAPM)
d. the higher the beta, the greater the risk level
b. it measures the volatility of returns relative to the expected value
Projects that increase the overall risk level of the firm:

a. should not be undertaken
b. should be discounted at the firm's cost of capital
c. should be discounted at a rate higher than the cost of capital
d. will have a low standard deviation
c. should be discounted at a rate higher than the cost of capital
All methods used in evaluating risk in capital budgeting have one thing in common:

a. they use the coefficient of variation to determine the discount rate
b. risk classes are used to determine discount rates
c. they use computer-based statistical analysis
d. they recognize the differences in risk levels and adjust for them
d. they recognize the differences in risk levels and adjust for them
The key to simulation analysis has been:

a. statistical analysis
b. the development of the computer
c. risk adjusted interest rates
d. the ability to classify investments as to their risk class
b. the development of the computer
All of the following are true regarding the use of simulation techniques except:

a. the computer randomly selects inputs from probability distributions
b. sensitivity testing allows for the asking of "what if" questions
c. its applications are limited in the area of capital budgeting
d. they generate a range of outcomes with standard deviations
c. its applications are limited in the area of capital budgeting
A decision tree analysis:

a. lays out the sequence of decisions and presents a graphical comparison
b. is a form of simulation analysis
c. tends to be more accurate than simulation techniques
d. should be utilized as the sole input for the decision making process
a. lays out the sequence of decisions and presents a graphical comparison
The portfolio effect analyzes:

a. the return on the portfolio
b. the risk of the portfolio
c. the impact of a given investment on the overall risk level
d. none of the above are correct
c. the impact of a given investment on the overall risk level
The extent of correlation among projects is represented by:

a. the coefficient of correlation
b. the coefficient of variation
c. the standard correlation coefficient
d. the variance
a. the coefficient of correlation
The efficient frontier represents:

a. the difference between investment returns
b. optimal risk-return tradeoffs
c. the correct investment for all firms to make
d. the correlation between profits and the portfolio effect
b. optimal risk-return tradeoffs
beta:
A measure of the volatility of returns on an individual stock relative to the market. Stocks with a beta of 1.0 are said to have risk equal to that of the market (equal volatility). Stocks with betas greater than 1.0 have more risk than the market, while those with betas of less than 1.0 have less risk than the market.
certainty equivalents:
The adjustment of uncertain cash flows as represented by a probability distribution to a value that is considered equal and certain.
coefficient of correlation:
The degree of associated movement between two or more variables. Variables that move in the same direction are said to be positively correlated, while negatively correlated variables move in opposite directions.
coefficient of variation:
A measure of risk determination that is computed by dividing the standard deviation for a series of numbers by the expected value. Generally, the larger the coefficient of variation, the greater the risk.
decision tree:
A tabular or graphical analysis that lays out the sequence of decisions that are to be made and highlights the differences between choices. The presentation resembles branches on a tree.
efficient frontier:
A line drawn through the optimum point selections in a risk-return trade-off diagram. Each point represents the best possible trade-off between risk and return (the highest return at a given risk level or the lowest risk at a given return level).
expected value:
A representative value from a probability distribution arrived at by multiplying each outcome by the associated probability and summing up the values.
portfolio effect:
The impact of a given investment on the overall risk-return composition of the firm. A firm must consider not only the individual investment characteristics of a project, but also how the project relates to the entire portfolio of undertakings.
risk:
A measure of uncertainty about the outcome from a given event. The greater the variability of possible outcomes, on both the high side and the low side, the greater the risk.
risk averse:
An aversion or dislike for risk. To induce most people to take larger risks, there must be increased potential for return.
risk-adjusted discount rate:
A discount rate used in the capital budgeting process that has been adjusted upward or downward from the basic cost of capital to reflect the risk dimension of a given project.
sensitivity analysis:
The altering of one variable at a time within an analysis to determine that variable's impact on the results of the analysis.
simulation:
A method of dealing with uncertainty in which future outcomes are anticipated. The model may use random variables for inputs. By programming the computer to randomly select inputs from probability distributions, the outcomes generated by a simulation are distributed about a mean; instead of generating one return or net present value, a range of outcomes with standard deviations is provided.
standard deviation:
A measure of the spread or dispersion of a series of numbers around the expected value. The standard deviation tells us how well the expected value represents a series of values.