The Role of Risk in Capital Budgeting

Risk Aversion

Risk aversion describes how people react to conditions of uncertainty and has implications for investment decisions.

In finance and economics, Risk Aversion is a concept that addresses how people will react to a situation with uncertain outcomes.

High dividend gambles: Risk aversion can be applied to many different situations, including investments, lotteries, and any other situations with uncertain outcomes.

It attempts to measure tolerance for risk and uncertainty. Risk aversion is the reluctance of a person to accept a bargain with an uncertain payoff rather than another bargain with a more certain but possibly lower expected payoff. For example, a risk-averse investor might choose to put his or her money into a bank account with a low but guaranteed interest rate instead of investing in a stock that may have high expected returns but also involves a chance of losing value.

Risk aversion can be applied to many different situations, including investments, lotteries, and other situations with uncertain outcomes. Because organizations are composed of individuals, risk aversion at the individual level plays a role in organizational decision-making.

People fall into different categories of risk aversion. If we look at an example where a person could receive $50 without risk or take a gamble where they receive $100 or $0 depending on the outcome of a coin flip, we can explain the differences. When we use the expected payoffs of each scenario, we see that each has an expected payoff of $50.

Situation 1 has a 100% chance of getting $50, so its expected payoff is (1)(50)=50. For Situation 2, the expected payoff deals with a 50-50 chance of getting $100 or $0, so (.5)(100)+(.5)(0)=50.

This is important to know for this example. A risk-averse or risk-avoiding person would take the guaranteed payment of $50 or even less than that ($40 or $30), depending on how risk-averse they are. A risk-neutral person would be indifferent between gambling and guaranteed money.

Finally, a risk-loving person would take the non-guaranteed chance of possibly winning $100 rather than settling for the guaranteed option. If the guaranteed option was greater than $50, then the risk lover might consider taking it.

This can be extended to capital budgeting. A firm's management can adopt different stances based on how risk-averse they feel they should be, given different market qualities and firm conditions. They will make capital investments that they feel will have the best payoffs, given the risks involved, and if they take a more risk-averse stance, they will make capital investment decisions that have a more guaranteed payoff. On the other hand, if they are more risk-loving, they will be attracted to the more risky investments for capital that they believe have a chance for a higher payoff.