Risk analysis in capital budgeting
United Recycling Inc. is one of the largest recyclers of glass and paper products in the United States. The company is looking into expanding into the cardboard recycling business. The company’s CFO has performed a detailed analysis of the proposed expansion.
The company’s CFO used sophisticated software to analyze a large number of scenarios and generate estimated rates of return and risk indexes.
- Based on the information given, determine which of the statement siscorrect:
- The company’s CFO conducted a sensitivity analysis to evaluate the project’s financial model.
b. The compnay’s CFO used a Monte Carlo simulation to evaluate the project’s financial model - Evaluating risk is an important part of the capital budgeting process. Which of the following is measured by its effect on the firm’s beta coefficient?
- Market, or beta, risk
b. Risk-adjusted cost of capital
c. Corporate, or within-fim, risk
d. Stand-alone risk
Answer
The company’s CFO used sophisticated software to analyze a large number of scenarios and generate estimated rates of return and risk indexes.
Answer :B; . The company’s CFO used a Monte Carlo simulation to evaluate the project’s financial model
Explanation to the above answer:
Monte Carlo simulation used for adjusting risk. This method is used for the situation of different outcomes in a process that cannot easily be predicted due to the intervention of random on the other hand Sensitivity analysis, generally makes analysis of inflation adjusted cash flows, economic value added, and incremental IRR along with NPV and IRR. So for the present situation statement B is correct
2
Evaluating risk is an important part of the capital budgeting process. Which of the following is measured by its effect on the firm’s beta coefficient?
Answer: Stand alone Risk
Explanation to the above answer:
If the person want to find risk is an important part of the capital budgeting process he need to find stand alone risk and ot Beta of firm or market because Beta is a measurement of how a particular firm’s returns move relative to overall changes in the situation . So for the present situation statement Stand alone Risk is correct
3
Corporate risk is measured by the projects impact on uncertainty about the firms future Return.
