Chapter 11 - Chapter 11 - Capital Budgeting Capital Budgeting and Risk Analysisand Risk Analysis

2005, Pearson Prentice Hall

Three Measures of a Project’s RiskThree Measures of a Project’s Risk

Project Standing Alone Risk

Three Measures of a Project’s RiskThree Measures of a Project’s Risk

Project Standing Alone Risk

Risk diversified away

within firm as thisproject is combined

with firm’s otherprojects and assets.

Three Measures of a Project’s RiskThree Measures of a Project’s Risk

Project Standing Alone Risk

Risk diversified away

within firm as thisproject is combined

with firm’s otherprojects and assets

Project’sContribution-to-Firm Risk

Three Measures of a Project’s RiskThree Measures of a Project’s Risk

Project Standing Alone Risk

Risk diversified away

within firm as thisproject is combined

with firm’s otherprojects and assets.

Risk diversified away

by shareholders as securities are combined

to form diversifiedportfolio.

Project’sContribution-to-Firm Risk

Three Measures of a Project’s RiskThree Measures of a Project’s Risk

Project Standing Alone Risk

Risk diversified away

within firm as thisproject is combined

with firm’s otherprojects and assets.

Risk diversified away

by shareholders as securities are combined

to form diversifiedportfolio.

Project’sContribution-to-Firm Risk

Systematic Risk

Incorporating Risk into Incorporating Risk into Capital BudgetingCapital Budgeting

Two Methods:Two Methods: Certainty Equivalent ApproachCertainty Equivalent Approach Risk-Adjusted Discount RateRisk-Adjusted Discount Rate

How can we adjust this model to How can we adjust this model to take risk into account?take risk into account?

NPV = - IO FCFt

(1 + k) t

n

t=1

How can we adjust this model to How can we adjust this model to take risk into account?take risk into account?

Adjust the After-tax Cash Flows (ACFs), Adjust the After-tax Cash Flows (ACFs), oror

Adjust the discount rate (k).Adjust the discount rate (k).

NPV = - IO FCFt

(1 + k) t

n

t=1

Certainty Equivalent Certainty Equivalent ApproachApproach

Adjusts the Adjusts the riskyrisky after-tax cash flows after-tax cash flows to to certaincertain cash flows. cash flows.

The idea: The idea:

Certainty Equivalent Certainty Equivalent ApproachApproach

Adjusts the Adjusts the riskyrisky after-tax cash flows after-tax cash flows to to certaincertain cash flows. cash flows.

The idea: The idea:

Risky Certainty CertainRisky Certainty Certain

Cash Cash XX EquivalentEquivalent = = Cash Cash

Flow Factor (a) FlowFlow Factor (a) Flow

Certainty Equivalent Certainty Equivalent ApproachApproach

Risky Certainty CertainRisky Certainty Certain

Cash Cash X X EquivalentEquivalent = = Cash Cash

Flow Factor (a) FlowFlow Factor (a) Flow

Risky “safe”Risky “safe”

$1000 .70 $700$1000 .70 $700

Certainty Equivalent Certainty Equivalent ApproachApproach

Risky Certainty CertainRisky Certainty Certain

Cash Cash X X EquivalentEquivalent = = Cash Cash

Flow Factor (a) FlowFlow Factor (a) Flow

Risky “safe”Risky “safe”

$1000 .95 $950$1000 .95 $950

The The greatergreater the risk associated the risk associated with a particular cash flow, with a particular cash flow, the the smallersmaller the CE factor. the CE factor.

Certainty Equivalent MethodCertainty Equivalent Method

tNPV = - IO t ACFt

(1 + krf)

n

t=1

Certainty Equivalent ApproachCertainty Equivalent Approach

Steps:Steps:

1) Adjust all after-tax cash flows by 1) Adjust all after-tax cash flows by certainty equivalent factors to get certainty equivalent factors to get certain cash flows.certain cash flows.

2) Discount the certain cash flows by 2) Discount the certain cash flows by the the risk-free raterisk-free rate of interest. of interest.

Incorporating Risk into Incorporating Risk into Capital BudgetingCapital Budgeting

Risk-Adjusted Discount RateRisk-Adjusted Discount Rate

How can we adjust this model How can we adjust this model to take risk into account?to take risk into account?

NPV = - IO NPV = - IO ACFACFtt

(1 + k)(1 + k) tt

nn

t=1t=1

How can we adjust this model How can we adjust this model to take risk into account?to take risk into account?

Adjust the discount rate (k).Adjust the discount rate (k).

NPV = - IO NPV = - IO ACFACFtt

(1 + k)(1 + k) tt

nn

t=1t=1

Risk-Adjusted Discount RateRisk-Adjusted Discount Rate

Simply Simply adjust the discount rate (k)adjust the discount rate (k) to to reflect higher risk.reflect higher risk.

Riskier projects will use Riskier projects will use higherhigher risk- risk-adjusted discount rates.adjusted discount rates.

Calculate NPV using the new risk-Calculate NPV using the new risk-adjusted discount rate.adjusted discount rate.

Risk-Adjusted Discount RateRisk-Adjusted Discount Rate

NPV = - IO FCFt

(1 + k*)t

n

t=1

Risk-Adjusted Discount RatesRisk-Adjusted Discount Rates

How do we determine the How do we determine the appropriate risk-adjusted discount appropriate risk-adjusted discount rate rate (k*)(k*) to use? to use?

Many firms set up Many firms set up risk classesrisk classes to to categorize different types of categorize different types of projects.projects.

Risk ClassesRisk Classes

Risk RADR Risk RADR

ClassClass (k*) (k*) Project Type Project Type

1 12% Replace equipment,1 12% Replace equipment,

Expand current businessExpand current business

2 14% Related new products 2 14% Related new products

3 16% Unrelated new products3 16% Unrelated new products

4 24% Research & Development4 24% Research & Development

Summary:Summary: Risk and Risk and Capital BudgetingCapital Budgeting

You can adjust your capital budgeting You can adjust your capital budgeting methods for projects having different levels methods for projects having different levels of risk by:of risk by:

Adjusting the Adjusting the discount ratediscount rate used (risk- used (risk-adjusted discount rate method),adjusted discount rate method),

Measuring the project’s systematic risk,Measuring the project’s systematic risk, Analyzing computer simulation methods,Analyzing computer simulation methods, Performing scenario analysis, andPerforming scenario analysis, and Performing sensitivity analysis.Performing sensitivity analysis.