Methods of Risk Assessment

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List three methods commonly used to adjust for project risk in the capital budgeting process and discuss why these methods might be appropriate.

Payback Period
This is the amount of time required for the firm to recover its initial investment in a project, as calculated from cash inflows. Used to evaluate propose investments. The payback period is widely used by large firms to evaluate small projects and by small firms to evaluate most projects. It considers cash flows rather than accounting profits. Because it is a measure of risk exposure, firms use it as a decision criterion or as a supplement to other decision techniques. The shorter the payback period, the lower the firm’s exposure to such risk. Decision Criteria:

If the payback period is less than the maximum acceptable payback period, accept the project. •If the payback period is greater than the maximum acceptable payback period, accept the project Net Present Value (NPV)

Because NPV gives explicit consideration to the time value of money. All the techniques in one way or another discount the firm’s cash flows at a specified rate - the minimum return that must be earned on a project to leave the firms market value unchanged. The NPV is found by subtracting a projects initial investment (CF0) from the PV of its cash inflows (CFt) discounted at a rate equal to the firms cost of capital. Decision Criteria:

If the NPV is greater than $0, accept the project. The firm will earn a return greater than its cost of capital •If the NPV is less than $0, reject the project.
Internal Rate of Return
IRR is the discount rate that equates the NPV of an investment opportunity with $0 because the present value of cash flow equates the initial investment. It is the compound annual rate of return that the firm will earn if it invests in the project and receives the cash inflows. Decision Criteria

If the IRR is greater than the cost of capital, accept the project •If the IRR is less than the cost of...
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