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Summary Capital Budgeting Essay Plan
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Bullet point essay outline on capital budgeting and the risk adjusted rate of return
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Discuss the benefits and limitations of risk-adjusted rate of return approach when dealingwith risk in capital budgeting decisions.
Initial Plan:
Points to add:
Explain the NPV Method; in this method discount rate reflects compensation for risk,
explain relationship between the discount rate and NPV values given different levels of
risk.
Provide a numerical illustration as an example.
What is Capital Budgeting and in what situations can it occur
Define Risk adjusted rate of return: Approach that adjusts the required
rate of return for investors to reflect the level of risk associated with
investing in projects with different risk levels.
Involves Adding a ‘risk premium’ to the risk-free rate of return = the
greater the risk, the greater the risk premium
Risk free rate of return = Rate of return based on government securities
such as Treasury Bills
Benefits Limitations
Acknowledges risk and follows Assumes that risk estimates
assumption of investors being are accurate and required
risk averse; Risk adjusted rates of return remain stable
return approach links to two Small firms may not have the
key principles of finance; risk expertise or tools to complete
requires reward and that this
investors are risk averse so
taking on a risky investment
requires a greater return.
Comparability of Projects; managers Allocation of Projects to risk classes
can classify projects into different and premiums; likely estimates
risk classes depending on risk levels based on managers attitudes to risk
with different discounting factors; aversion on different projects; may
comparability within risk classes disagree with investors; ‘principal-
agent problem’
Better Decision Making; Produces a Constant Risk Premium; implies that
risk adjusted NPV; investors can risk increases over time as cash
make accurate decisions. flows go into the future; may not
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