Introduction and Project Risk

Question 1

Define “capital budgeting.”

Answer 1

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

Question 2

Define “risk premium.”

Answer 2

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

Question 3

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

Answer 3

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

Question 4

Define “risk.”

Answer 4

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

Question 5

Give examples of risk associated with investments in capital projects.

Answer 5

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

Question 6

Describe the risk/reward relationship.

Answer 6

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

Question 7

Define “risk free rate of return.”

Answer 7

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