Introduction and Project Risk

Question 1

Describe the relationship between a firm’s capital projects and the firm’s capital that funds those projects.

Answer 1

The rate of return earned on a firm’s capital projects must be equal or greater than the rate of return required to attract and maintain investors’ capital.

Question 2

Define “capital budgeting”.

Answer 2

The process of measuring, evaluating, and selecting long-term investment opportunities, primarily in the form of projects or programs.

Question 3

Describe the risk/reward relationship.

Answer 3

The greater the perceived risk of an undertaking, the higher the expected reward from the undertaking.

Question 4

Define “risk premium”.

Answer 4

The rate of return expected above the risk-free rate based on the perceived level of risk inherent in an investment/undertaking.

Question 5

Define “risk”.

Answer 5

The possibility of loss or other unfavorable results that derives from the uncertainty implicit in future outcomes.

Question 6

Define “risk-free rate of return”.

Answer 6

The rate of return expected solely for the deferred current consumption that results from making an investment; rate of return expected assuming virtually no risk. In the United States it is measured by the rates paid on United States Treasury obligations.

Question 7

Give examples of risk associated with investments in capital projects.

Answer 7

1. Incomplete or incorrect analysis of a project
2. Unanticipated actions of customers, suppliers, and competitors
3. Unanticipated changes in laws, regulations, etc.
4. Unanticipated macroeconomic changes (e.g., interest rates, inflation/deflation, tax rates, currency exchange rates, etc.)