Understanding Risk Attitude and Capital Budgeting (Essay Sample)

FINANCE
Student’s Name
Course Name and Number
Professor
Institution
Date
Finance
Question 1
Risk Attitude is majorly at a high level. It indicates the natural inclination as well as stakeholders’ basic nature if willing to take risks. Risk attitudes represent responses that stakeholders choose and are driven by their perception regarding a particular situation. The three risk attitude types include risk seeker, risk Averser as well as Risk Neutral. It is not easy to determine risk attitude and it comes close to risk appetite, which refers to stakeholders’ desire to take risks to obtain a particular objective. For instance, the manager of a particular company might not be willing to take risks in producing more goods as they fear encountering high production costs that will lead to increased cost of goods. The managers fear that customers might fail to purchase these goods due to the increased prices. Therefore, in this case, the managers lack a risk attitude. In econometrics, the utility function is an essential concept used in determining preferences over a set of goods as well as services (Damodaran, 2012). Utility function represents satisfaction received by consumers for choosing as well as consuming services and even products.
Question 2
Capital budgeting refers to the process used by an organization in determining the proposed fixed asset purchases to choose and accept and the ones to decline. There are both modern as well as conventional methods of capital budgeting. Capital budgeting adopts different methods such as traditional as well as modern methods. The traditional methods comprise of payback period as well as the the return rate accounting method. The payback period method is the period whereby the proposal generates cash used in recovering the initial investment (Brealey, Myers, Allen, and Mohanty, 2012). The method focuses on cash inflows, the project's economic life as well as investment without considering the money’s time value.
Payback Period= Cash outlay (investment)/ Annual Cash Flow
The Accounting rate of return method aids in overcoming the payback’s period disadvantages. The return rate is expressed in form of the earning’s investment percentage in a specific project.
ARR= Average income divided by Average Investment
Example
 

Project A

 

Project B

Cost

10,000

 

20000

Expected FCF




Year 1

20,000

 

40,000

Year 2

10,000

 

500

Year 3

4000

 

3000

Year 4

N/A

 

N/A

TOTAL

10000

 

20000

Payback

3

 

2

Project B has a shorter payback period compared to project A though gives higher returns and thus this makes it superior to B.
Modern methods comprise of net present value (NPV), Internal return rate as well as profitability index method. In NPV, the cash inflow expected in various periods gets discounted at a specific time.
NPV= PVB subtractPVC
Where,
PVB refers to the present benefit’s value and
PVC the Present cost’s Value
The internal return rate is expressed as a rate whereby the investment’s NPV is zero. The technique considers money’s time value. It is referred to as internal rate since it relies on the outlay related to the project.
Question 3
Risk perceptions refer to beliefs regarding potential harm as well as the possibility of any loss. It is a subjective judgment made by individuals regarding risk characteristics and even severity. On the other hand, risk segmentation is among the many ways used by organizations to handle higher risks through segmenting them into risk tiers and then charge various charges for the different tiers (Mishkin, 2016). Risk measurement explains the overall process of evaluating hazards as well as risk factors with the possibility of bringing harm.