Asked Jul 28, 2019

Participation #6: 

 Why is it desirable to construct capital budgeting rules so that higher-risk projects become less acceptable than lower-risk projects?


Expert Answer

Step 1

A risk is a probability of unfavorable outcome. All investments are subjected to risks.  

So, a high risk project has higher probability of unfavorable outcome. The probability that we will miss the anticipated cash flows is higher. The probability of loss is higher.

A low risk project has lower porbability of unfvorable otcome. There is a higher likelihood that we will end up getting the anticpitated or expected cash flows.

Step 2

Imagine a situation where there is no such rule which leads to lower acceptance of high risk project. A firm will therefore end up having large number of higher risk projects where:

  • Significant capital investments have been made
  • But there is no visibility of cash flows
  • And even if there is vi...

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