Distinguish among beta (or market) risk, within-firm (or corporate) risk, and stand-alone risk for a project being considered for inclusion in a firm’s capital budget.

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Distinguish among beta (or market) risk, within-firm (or corporate) risk, and stand-alone risk for a project being considered for inclusion in a firm’s capital budget.

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Distinguish among beta (or market) risk, within-firm (or corporate) risk, and stand-alone risk for a project being considered for inclusion in a firm’s capital budget.

Explanation & AnswerSolution by a verified expert

Explanation

Market risk is captured by the sensitivity factor beta, which measures changes in the stock in response to changes in the overall market. Market risk is an external risk and is out of the firm's control, as it affects overall markets. Examples of such risks include geopolitical tensions and macro economy-specific risks. Market risk is the most significant risk as it directly influences stock prices.
 
 
Corporate or within-firm risk assumes a project is one of various other assets in the portfolio and that any project risk could be diversified away with other firm assets. Such risks are internal risks and can be controlled by the firm.
 
 
Stand-alone risk measures the risk of the project in isolation and completely ignores any diversification benefits. Stand-alone risk assumes there is only one project in the firm portfolio and the firm is the only stock that the investor holds. The stand-alone risk of a project is determined through the deviation of expected returns, and the project is considered as the only operating entity.

Sample Response

Market risk is captured with a sensitivity factor named beta. Such risks are external in nature and are not within the firm's control. Examples of such risks include macroeconomic risks and political risks.
 
 
Within-firm or corporate risk refers to the risk of the project and its effect on the firm's other projects. Corporate risk assumes the benefit of diversification, as the risk of one project could be diversified with other projects in the firm's portfolios.
 
 
Stand-alone risk is the risk of assuming a project is the only asset in the firm and that the firm is the only stock in an investor's portfolio. Stand-alone risks are created from the project's internal operations, and such risks are completely undiversified.

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