Chapter 12
The Role of Risk in Capital Budgeting
By Boundless
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The process of capital budgeting must take into account the different risks faced by corporations and their managers.
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Risk aversion describes how people react to conditions of uncertainty and has implications for investment decisions.
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Some of the quantitative definitions of risk are grounded in statistical theory and lead naturally to statistical estimates, but some are more subjective.
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Sensitivity analysis determines how much a change in an input will affect the output.
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Scenario analysis is a process of analyzing decisions by considering alternative possible outcomes.
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Monte Carlo simulation uses statistical data to figure out the average outcome of a scenario based on multiple, complex factors.
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A decision tree is a decision support tool that uses a tree-like graph or model of decisions and their possible consequences.
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Discount rates are adjusted on an investment to investment basis, as different investments encounter different degrees of risk that must be considered when determining equitable returns.
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A longer time horizon usually requires a higher return, due to increased price volatility and uncertainty relating to possible outcomes.