Question

1. Describe the three types of project risk. Under what situation is each of the types most relevant to the capital budgeting decision? Which type of risk is easiest to measure in practice?
2. Describe the qualitative approach to risk assessment. Why does this approach, which does not rely on numerical data, work?

Answer 1

Answer:

Three types of project risk- Are as following:

Cost Risk- This is the risk that the project cost can increase from the budgeted cost. This also arises when futures expected cash flow are lower than the initial cost of the project and Net present value is negative, in that case project will be rejected.

Environment safety and health risk- This risk arises when project may have negative and harmful effect on environment and society. Project may affect the health of the people if it contains plastic, dangerous chemical or gases.

Schedule risk- This risk includes the longer duration of the project. Project may take longer time than expected. It will take more time to generate cash flows.

Relevance to Capital budgeting decision- Capital budgeting decision includes the approval or rejection of a particular project. It has some techniques with the help of which, project is evaluated. In the above risks, cost risk and schedule risk are related to capital budgeting. Sometimes project cost is so high as the expected future cash flows cannot meet the cost, in that case, NPV is negative and project is rejected.

Sometimes when Payback period is calculated, it takes many years to cover the initial cost of the project. The cash flows duration is longer that is the reason, managers do not accept the project due to longer duration.

Cost risk is easier to measure because cost is estimated and budgeted cost is compared to the actual cost of the project