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4. Risk Adjusting the Discount Rate Risk Adjusting for the Time Horizon Factors Impacting Capital Budgeting The Role of Risk in Capital Budgeting > Factors Impacting Capital Budgeting Free to share, print, make copies and changes. Get yours at www.boundless.com www.boundless.com/finance?campaign_content=book_192_section_100&campaign_term=Finance&utm_campaign=powerpoint&utm_medium=di rect&utm_source=boundless

5. The risks taken into account in modeling are typically grouped into credit risk, liquidity risk, market risk, and operational risk categories. Risk will increase with the amount of uncertainty involved in the investment ( i.e., the amount of possible outcomes associated with it). Risk will also increase due to the amount of variation in the possible outcomes. The Sharpe ratio characterizes how well the return of an asset compensates the investor for the risk taken. Risk-adjusted net present value is an alternative method to simple net present value, used to value future cash flows that are risky. The Monte Carlo evaluation method is used to value and analyze complex investments by simulating various sources of uncertainty affecting their value, and then determining their average value over the range of resultant outcomes. Risk Adjusting the Discount Rate Free to share, print, make copies and changes. Get yours at www.boundless.com www.boundless.com/finance/textbooks/boundless-finance-textbook/the-role-of-risk-in-capital-budgeting-12/factors-impacting-capital-budgeting- 100/risk-adjusting-the-discount-rate-430- 3548?campaign_content=book_192_section_100&campaign_term=Finance&utm_campaign=powerpoint&utm_medium=direct&utm_source=boun dless Beta Equation View on Boundless.com The Role of Risk in Capital Budgeting > Factors Impacting Capital Budgeting

6. In terms of debt investments, default risk increases as the time horizon lengthens. Since stock investments have more time to overcome potential downturns in value, having a longer time horizon can justify more aggressive investing. When there are multiple possible outcomes, management of a firm may choose to undertake real options analysis in order to factor in the various possibilities. Risk Adjusting for the Time Horizon Free to share, print, make copies and changes. Get yours at www.boundless.com www.boundless.com/finance/textbooks/boundless-finance-textbook/the-role-of-risk-in-capital-budgeting-12/factors-impacting-capital-budgeting- 100/risk-adjusting-for-the-time-horizon-431- 699?campaign_content=book_192_section_100&campaign_term=Finance&utm_campaign=powerpoint&utm_medium=direct&utm_source=boundl ess Performance of Stocks, Bonds and Bills View on Boundless.com The Role of Risk in Capital Budgeting > Factors Impacting Capital Budgeting

7. Free to share, print, make copies and changes. Get yours at www.boundless.com Appendix

8. Key terms covariance A measure of how much two random variables change together. Risk free rate Risk-free interest rate is the theoretical rate of return of an investment with no risk of financial loss. salvage value The estimated value of an asset at the end of its useful life. time horizon The period of time the asset is expected to be held or a project is expected to last. Free to share, print, make copies and changes. Get yours at www.boundless.com The Role of Risk in Capital Budgeting

9. Performance of Stocks, Bonds and Bills This graph gives an illustration of investing a dollar in different asset classes in the market from 1926 to the end of 2007. Free to share, print, make copies and changes. Get yours at www.boundless.com Wikimedia. "Performance of stocks, bonds and bills." CC BY-SA http://commons.wikimedia.org/wiki/File%253APerformance_of_stocks%252C_bonds_and_bills.png View on Boundless.comCC BY-SA http://commons.wikimedia.org/wiki/File%253APerformance_of_stocks%252C_bonds_and_bills.pngView on Boundless.com The Role of Risk in Capital Budgeting

10. Beta Equation Beta is equal to the covariance between the return of the asset and the return of the market (or portfolio), divided by the variance in the returns of the market. Free to share, print, make copies and changes. Get yours at www.boundless.com Wikipedia. "Beta (finance)." GNU FDL http://en.wikipedia.org/wiki/Beta_(finance) View on Boundless.comGNU FDLhttp://en.wikipedia.org/wiki/Beta_(finance)View on Boundless.com The Role of Risk in Capital Budgeting

11. The Sharpe Ratio The equation for calculating the Sharpe Ratio Free to share, print, make copies and changes. Get yours at www.boundless.com Wikipedia. "Sharpe ratio." GNU FDL http://en.wikipedia.org/wiki/Sharpe_ratio View on Boundless.comGNU FDLhttp://en.wikipedia.org/wiki/Sharpe_ratioView on Boundless.com The Role of Risk in Capital Budgeting

12. Free to share, print, make copies and changes. Get yours at www.boundless.com The Role of Risk in Capital Budgeting Which of the following correctly defines a method used to adjust a company's discount rate for risk? A) The Monte Carlo method analyzes complex investments by simulating various sources of uncertainty. B) The Sharpe Ratio modifies the standard NPV calculation by adjusting each cash flow by its probability of occurrnce. C) rNPV is a measure of risk premium per unit of deviation in an investment asset. D) All of these answers.

13. Free to share, print, make copies and changes. Get yours at www.boundless.comwww.boundless.com Boundless - LO. "Boundless." CC BY-SA 3.0 http://www.boundless.com/CC BY-SA 3.0http://www.boundless.com/ The Role of Risk in Capital Budgeting Which of the following correctly defines a method used to adjust a company's discount rate for risk? A) The Monte Carlo method analyzes complex investments by simulating various sources of uncertainty. B) The Sharpe Ratio modifies the standard NPV calculation by adjusting each cash flow by its probability of occurrnce. C) rNPV is a measure of risk premium per unit of deviation in an investment asset. D) All of these answers.

14. Free to share, print, make copies and changes. Get yours at www.boundless.com The Role of Risk in Capital Budgeting Which of the following statements regarding an investment's time horizon and its risk is correct? A) For some stock investments, a longer-term investment may be considered safer than short-term. B) It is important to diversify your investments based on how long each will be held. C) An investment with a longer time horizon will generally require a higher return. D) All of these answers.

15. Free to share, print, make copies and changes. Get yours at www.boundless.comwww.boundless.com Boundless - LO. "Boundless." CC BY-SA 3.0 http://www.boundless.com/CC BY-SA 3.0http://www.boundless.com/ The Role of Risk in Capital Budgeting Which of the following statements regarding an investment's time horizon and its risk is correct? A) For some stock investments, a longer-term investment may be considered safer than short-term. B) It is important to diversify your investments based on how long each will be held. C) An investment with a longer time horizon will generally require a higher return. D) All of these answers.

16. Attribution Wikipedia. "Real options analysis." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Real_options_analysisCC BY-SA 3.0http://en.wikipedia.org/wiki/Real_options_analysis Managing Money. "ManagingMoney.com Money Blog: Asset Allocation Tips." CC BY http://www.managingmoney.com/weblog/2007/01/asset_allocation_tips.htmlCC BY http://www.managingmoney.com/weblog/2007/01/asset_allocation_tips.html Wikipedia. "salvage value." CC BY-SA 3.0 http://en.wikipedia.org/wiki/salvage%20valueCC BY-SA 3.0http://en.wikipedia.org/wiki/salvage%20value Wiktionary. "time horizon." CC BY-SA 3.0 http://en.wiktionary.org/wiki/time+horizonCC BY-SA 3.0http://en.wiktionary.org/wiki/time+horizon OER Commons. CC BY http://www.oercommons.org/courses/capital-budgeting-analysis/viewCC BYhttp://www.oercommons.org/courses/capital-budgeting-analysis/view Wikipedia. "Monte Carlo methods in finance." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Monte_Carlo_methods_in_financeCC BY-SA 3.0http://en.wikipedia.org/wiki/Monte_Carlo_methods_in_finance Wikipedia. "Market risk." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Market_riskCC BY-SA 3.0http://en.wikipedia.org/wiki/Market_risk Wikipedia. "RNPV." CC BY-SA 3.0 http://en.wikipedia.org/wiki/RNPVCC BY-SA 3.0http://en.wikipedia.org/wiki/RNPV Wikipedia. "Credit risk." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Credit_riskCC BY-SA 3.0http://en.wikipedia.org/wiki/Credit_risk Wikipedia. "Liquidity risk." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Liquidity_riskCC BY-SA 3.0http://en.wikipedia.org/wiki/Liquidity_risk Wikipedia. "Risk modeling." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Risk_modelingCC BY-SA 3.0http://en.wikipedia.org/wiki/Risk_modeling Wikipedia. "Sharpe ratio." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Sharpe_ratioCC BY-SA 3.0http://en.wikipedia.org/wiki/Sharpe_ratio Wikipedia. "Risk premium." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Risk_premiumCC BY-SA 3.0http://en.wikipedia.org/wiki/Risk_premium Wikipedia. "Beta (finance)." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Beta_(finance)CC BY-SA 3.0http://en.wikipedia.org/wiki/Beta_(finance) Wikipedia. "Operational risk." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Operational_riskCC BY-SA 3.0http://en.wikipedia.org/wiki/Operational_risk Wiktionary. "covariance." CC BY-SA 3.0 http://en.wiktionary.org/wiki/covarianceCC BY-SA 3.0http://en.wiktionary.org/wiki/covariance Wikipedia. "Risk free rate." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Risk%20free%20rateCC BY-SA 3.0http://en.wikipedia.org/wiki/Risk%20free%20rate Free to share, print, make copies and changes. Get yours at www.boundless.com The Role of Risk in Capital Budgeting