Capital Budgeting and Risk Management

Abstract

Evaluating whether a company should invest in a capital project requires an analysis of whether the project adds value to the company. Essential in the analysis of the attractiveness of a capital project is an assessment of the project’s risk. The analysis of the risk of a project is challenging because most capital projects are unique and a project’s contribution to the company’s risk is difficult to quantify. There are several tools available to help incorporate a project’s risk into the decision. These tools include the incorporation of a project’s market risk in the cost of capital, as well as the use of the adjusted present value. An alternative to the traditional approaches is the use of real options, which can be used to estimate the value of any options associated with a capital project.