Question

Explain how the concept of risk can be incorporated into the capital budgeting process

Short answer

The risk can be introduced to the capital budgeting process when higher returns are required for risky investments.

Step-by-step solution

Definition of the capital budgeting process

Capital budgeting is defined as the process which the company undertakes for the evaluation of potential major projects or investment decisions.

Risk can be incorporated into the capital budgeting process

The element of risk is introduced to the process of capital budgeting process by requiring higher returns for risky investments. One method of achieving this is to use the discount rates for investments that are risky in nature. This method helps in specifying the different discount rates for different risk categories which are measured using the coefficient of variation or some other factor.