Tools for measuring risk in Capital Budeting

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We can apply the same analysis to the relationship between the project's risk and the market portfolio's risk, which depends on the correlation coefficient between the rate of returns of the project under review and the market portfolio

The project's market beta measures the project's sensitivity to changes in the market portfolio's return. In other words, it measures the project's contribution to the market portfolio's risk. This is of most interest to the shareholders. It is important to note that even though the shareholders are technically the owners of the firm, they are expected to hold a well-diversified portfolio. In other words, the shareholders diversify their portfolios by holding stocks from other firms. Hence, they are most interested in how the new project undertaken by the firm affects the risk of a market portfolio (which is often used as a representation of a well-diversified portfolio). The project's market beta basically measures the project's contribution to the risk borne by the firm's stockholders.

As a result, we know that part of a project's risk is related to the firm's corporate risk (which is of interest to the firm's management) and part of it is related to the market risk (which is of interest to the firm's shareholders).

To measure a project's stand-alone risk:

Since a project's risk is related to the firm's corporate risk and the market risk, it is important we know how to measure a project's stand-alone risk. The standard deviation is the most common way of measuring a project's stand-alone risk, and it is incorporated into the four following techniques:

(i) sensitivity analysis
(ii) scenario analysis
(iii) Monte Carlo simulation, and
(iv) decision tree analysis.

(i) Sensitivity analysis

Sensitivity analysis is a technique that determines how a project's NPV or IRR reacts to changes in one of the project's key variables assuming the other variables remain unchanged. In other words, the financial manager is trying to determine how sensitive the project is to unexpected changes.

In order to perform a sensitivity analysis, the firm will need to first pick a base case situation as benchmark for comparison. After picking the base situation, the firm will start changing one of its key variables ...