The Complete CFO Handbook

Chapter 16. Capital Budgeting and Risk

Agenda

Item 1	Identify the relevant risk for evaluating a capital project.
Item 2	Explain project risk using statistical measures.
Item 3	Describe the different types of project risk.
Item 4	Explain how to calculate a project's market risk.
Item 5	Estimate a project's risk using the pure‐play method.
Item 6	Apply the capital asset pricing model to estimate a project's cost of capital.
Item 7	Describe the adjusted present value method and the reasons for its use in evaluating capital projects.
Item 8	Summarize the real options approach to the valuation of capital projects and compare this approach to the traditional capital budgeting methods.
Item 9	Describe the certainty equivalent approach for dealing with risk in capital budgeting.
Item 10	Explain how project risk is handled in practice.

The capital budgeting decisions that a CFO makes require analyzing for each potential project (1) its future cash flows, (2) the uncertainty with its future cash flows, and (3) the value of the future cash flows. When looking at the available investment opportunities, the CFO must determine the project or set of projects that is expected to add the most value to the company. This requires evaluating how each project's benefts compare with its costs. The projects that are expected to increase owners' wealth the most are the best ones. In weighing a project's benefts and its costs, the costs include both the cash flow necessary to make the investment (the investment outlay) and ...