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Chapter 11: Capital Budgeting and Risk Analysis

Chapter 11: Capital Budgeting and Risk Analysis.  2002, Prentice Hall, Inc. Project Standing Alone Risk. Three Measures of a Project’s Risk. Project Standing Alone Risk. Risk diversified away within firm as this project is combined with firm’s other projects and assets.

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Chapter 11: Capital Budgeting and Risk Analysis

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  1. Chapter 11:Capital Budgeting and Risk Analysis  2002, Prentice Hall, Inc.

  2. Project Standing Alone Risk Three Measures of a Project’s Risk

  3. Project Standing Alone Risk Risk diversified away within firm as this project is combined with firm’s other projects and assets Three Measures of a Project’s Risk

  4. Project Standing Alone Risk Risk diversified away within firm as this project is combined with firm’s other projects and assets Project’s contribution- to-firm risk Three Measures of a Project’s Risk

  5. Project Standing Alone Risk Risk diversified away within firm as this project is combined with firm’s other projects and assets Project’s contribution- to-firm risk Risk diversified away by shareholders as securities are combined to form diversified portfolio Three Measures of a Project’s Risk

  6. Project Standing Alone Risk Risk diversified away within firm as this project is combined with firm’s other projects and assets Project’s contribution- to-firm risk Risk diversified away by shareholders as securities are combined to form diversified portfolio Systematic risk Three Measures of a Project’s Risk

  7. Incorporating Risk into Capital Budgeting Two Methods: • Certainty Equivalent Approach • Risk-Adjusted Discount Rate

  8. n t=1 S ACFt (1 + k) NPV = - IO t How can we adjust this model to take risk into account?

  9. n t=1 S ACFt (1 + k) NPV = - IO t How can we adjust this model to take risk into account? • Adjust the After-tax Cash Flows (ACFs), or • Adjust the discount rate (k).

  10. Certainty Equivalent Approach • Adjusts the risky after-tax cash flows to certain cash flows. • The idea:

  11. Certainty Equivalent Approach • Adjusts the risky after-tax cash flows to certain cash flows. • The idea: Risky Certainty Certain Cash XEquivalent = Cash Flow Factor (a) Flow

  12. Certainty Equivalent Approach Risky Certainty Certain Cash X Equivalent = Cash Flow Factor (a) Flow Risky “safe” $1000 .70 $700

  13. Certainty Equivalent Approach Risky Certainty Certain Cash X Equivalent = Cash Flow Factor (a) Flow Risky “safe” $1000 .95 $950

  14. The greater the risk associated with a particular cash flow, the smaller the CE factor.

  15. n t=1 t ACFt (1 + krf) NPV = - IO Certainty Equivalent Method S t

  16. Certainty Equivalent Approach • Steps: 1) Adjust all after-tax cash flows by certainty equivalent factors to get certain cash flows. 2) Discount the certain cash flows by the risk-free rate of interest.

  17. Incorporating Risk into Capital Budgeting • Risk-Adjusted Discount Rate

  18. n t=1 S ACFt (1 + k) NPV = - IO t How can we adjust this model to take risk into account?

  19. n t=1 S ACFt (1 + k) NPV = - IO t How can we adjust this model to take risk into account? • Adjust the discount rate (k).

  20. Risk-Adjusted Discount Rate • Simply adjust the discount rate (k) to reflect higher risk. • Riskier projects will use higher risk-adjusted discount rates. • Calculate NPV using the new risk-adjusted discount rate.

  21. n t=1 S ACFt (1 + k*) NPV = - IO t Risk-Adjusted Discount Rate

  22. Risk-Adjusted Discount Rates • How do we determine the appropriate risk-adjusted discount rate (k*) to use? • Many firms set up risk classes to categorize different types of projects.

  23. Risk Classes Risk RADR Class (k*) Project Type 1 12% Replace equipment, Expand current business 2 14% Related new products 3 16% Unrelated new products 4 24% Research & Development

  24. Summary: Risk and Capital Budgeting You can adjust your capital budgeting methods for projects having different levels of risk by: • Adjusting the discount rate used (risk-adjusted discount rate method), • Measuring the project’s systematic risk, • Computer simulation methods, • Scenario analysis, • Sensitivity analysis.

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