Handbook of Finance: Investment Management and Financial Management

Chapter 68. Capital Budgeting and Risk

PAMELA P. DRAKE, PhD, CFA

J. Gray Ferguson Professor of Finance and Department Head of Finance and Business Law, James Madison University

FRANK J. FABOZZI, PhD, CFA, CPA

Professor in the Practice of Finance, Yale School of Management

Abstract: Evaluating whether a company should invest in a capital project requires an analysis of whether the project adds value to the company. Essential in the analysis of the attractiveness of a capital project is an assessment of the project's risk. The analysis of the risk of a project is challenging because most capital projects are unique and a project's contribution to the company's risk is difficult to quantify. There are several tools available to help incorporate a project's risk into the decision. These tools include the incorporation of a project's market risk in the cost of capital, as well as the use of the adjusted present value. An alternative to the traditional approaches is the use of real options, which can be used to estimate the value of any options associated with a capital project.

Keywords: capital budgeting, Risk, total risk, stand-alone risk, sensitivity analysis, scenario analysis, simulation analysis, pure play, adjusted present value (APV), real options valuation (ROV), strategic net present value (NPV), certainty equivalent

Capital budgeting decisions require analyzing a proposed project's future cash flows, the uncertainty with its future cash flows, and the value of the future cash flows. ...