Portfolio theory makes it possible to incorporate Risk into capital budgeting through risk adjusted returns. However, portfolio theory omits an important element of risk that is relevant in capital budgeting. That missing element is:
A)systematic risk.
B)unsystematic risk.
C)market risk.
D)liquidity risk.

Question

Quizplus · Accepted Answer

Portfolio theory only considers systematic risk, which is the risk that cannot be diversified away, but omits unsystematic risk, which is the risk that can be diversified away through a well-diversified portfolio. In capital budgeting, unsystematic risk is relevant as it can be controlled by individual investment decisions, whereas systematic risk affects the entire market and cannot be controlled by the investor. Therefore, the missing element in portfolio theory relevant to capital budgeting is unsystematic risk (option B).

Portfolio Theory Makes It Possible to Incorporate Risk into Capital