What are the different methods used for evaluating risk in capital budgeting?

There are several methods used for evaluating risk in capital budgeting. Some of the commonly used methods include:

1. Sensitivity analysis: This method involves analyzing the impact of changes in key variables on the project's profitability. By varying one variable at a time while keeping others constant, sensitivity analysis helps identify the variables that have the most significant impact on the project's risk.

2. Scenario analysis: This method involves assessing the project's performance under different scenarios or sets of assumptions. By considering various possible outcomes, scenario analysis helps evaluate the project's risk in different situations.

3. Monte Carlo simulation: This method involves using statistical techniques to model the uncertainty and variability of key variables. By running multiple simulations, Monte Carlo simulation provides a range of possible outcomes and their associated probabilities, allowing for a more comprehensive evaluation of risk.

4. Decision trees: This method involves mapping out different decision paths and their associated probabilities and payoffs. Decision trees help visualize the potential outcomes and their probabilities, aiding in the assessment of risk and the identification of the optimal decision.

5. Risk-adjusted discount rate (RADR): This method involves adjusting the discount rate used in the net present value (NPV) calculation to reflect the project's risk. By incorporating a higher discount rate for riskier projects, RADR accounts for the uncertainty and helps evaluate the risk-adjusted profitability of the investment.

6. Capital asset pricing model (CAPM): This method involves estimating the project's required rate of return based on its systematic risk, as measured by beta. CAPM helps determine the appropriate discount rate for the project, considering its risk relative to the market.

It is important to note that these methods are not mutually exclusive, and a combination of them may be used to obtain a more comprehensive evaluation of risk in capital budgeting decisions.