TAILIEUCHUNG - Financial Analysis With Microsoft Excel-Mayes, Shank - Chapter 11

CHAPTER 11 Risk, Capital Budgeting, and Diversification Define the five major statistical measures used in finance and calculate these both manually and in Excel. Explain how risk can be incorporated into capital budgeting decisions, and show how to calculate the “risk-adjusted discount rate” (RADR) in Excel. | 11 Risk Capital Budgeting and Diversification After studying this chapter you should be able to 1. Define the five major statistical measures used in finance and calculate these both manually and in Excel. 2. Explain how risk can be incorporated into capital budgeting decisions and show how to calculate the risk-adjusted discount rate RADR in Excel. 3. Explain five alternative techniques for incorporating risk into the analysis. 4. Explain diversification and give an example using Excel. 5. Calculate portfolio risk measures with Excel. Risk is a difficult concept to define but most people recognize such obvious risks as swimming in shark-infested waters. If you consider risky situations for a moment you will realize that the thing that they all have in common is the possibility of a loss. Many times we face the loss of life or money. In this chapter we are concerned with the possibility of a financial loss. Specifically we will say that the larger the possibility of loss the larger the risk. We will begin by attempting to measure the riskiness of an investment and then we will consider how we can adjust our decision-making process to account for the risk 325 326 Risk Capital Budgeting and Diversification that we have measured. Finally we will consider how we can reduce risk through diversification. Review of Some Useful Statistical Concepts Any situation that has an uncertain outcome can be said to have a probability distribution associated with the possible outcomes. A probability distribution is simply a listing of the probabilities associated with potential outcomes. A probability distribution is said to be discrete if a limited number of potential outcomes are possible and continuous if an infinite number of possible outcomes can occur. Figure 11-1 illustrates both continuous and discrete probability distributions. Continuous probability distributions can be approximated by discrete distributions if we have enough possible outcomes. To keep things simple in .

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