If bankruptcy costs and/or shareholder under diversification are an issue, what measure of risk...

Question:

If bankruptcy costs and/or shareholder under diversification are an issue, what measure of risk is relevant when evaluating project risk in capital budgeting?

a) Total project risk

b) Contribution-to-firm risk

c) Systematic risk

d) Capital rationing risk.

Diversification:

For a diversified portfolio, the individual risk of an asset becomes less important to the overall portfolio risk, as more and more assets are included. Instead, the correlation between each asset's return with other asset becomes more important.

Answer and Explanation:

The answer is a).

When there is under-diversification, there is a relatively small pool of assets in the company. Given that bankruptcy costs are also an issue, the focus of the firm is less on the benefit of synergy between different projects (which tend to be limited anyway when asset pool is small), but more on ensuring the profitability of each project. In this case, the total project risk i the dominant risk.


Learn more about this topic:

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How to Reduce Investment Risks

from Finance 305: Risk Management

Chapter 3 / Lesson 8
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