1) What does the term “risk” mean in the context of capital budgeting; to what extent can risk be quantified; and, when risk is quantified, is the quantification based primarily on statistical analysis of historical data or on subjective, judgmental estimates?
The term “risk”, in the context of capital budgeting, means the uncertainty about the future profitability of the plan. We should understand if the taking on the project will rise both firm and stockholders’ risk. About the quantification, we should mainly use statistical analysis, but also historical data can be used and risk analysis in capital budgeting is usually focused on subjective judgments.
2) What are the three types of risk that are relevant in capital budgeting? How is each of these risk types measured, and how do they relate to one another? How is each type of risk used in the capital budgeting process?
Three main kind of risk are present in capital budgeting:
- Stand-alone risk
- Corporate risk
- Market risk.
The first one (Stand-Alone Risk) concerns the project’s risk if it is the only asset in the firm and no shareholders are there. It passes over both firm and shareholders’ diversification and it is computed by Sigma or CV of NPV, IRR or MIRR.
The second risk (that is Corporate Risk) concerns the project’s effect on corporate earnings stability. It also considers other activities of the firm (better knows as diversification within firm) and it depends on project’s sigma and the correlation (ρ) with performance on firm’s other assets.
The last one (Market Risk) considers project’s effect on a diversified stock portfolio, it takes into account about other shareholders’ activities. It depends on the project’s sigma and its correlation with stock market and it is calculated by project’s market beta.
About Market risk, it is probably the best one in many fields but just in theory. Anyway