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Contemporary Financial Management

Contemporary Financial Management. Chapter 11: Capital Budgeting and Risk. Introduction. This chapter considers adjusting a project’s risk level when it has more or less risk than the firm’s average level of risk. Risk. Project risk The risk that a project will perform below expectations

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Contemporary Financial Management

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  1. Contemporary Financial Management Chapter 11: Capital Budgeting and Risk

  2. Introduction • This chapter considers adjusting a project’s risk level when it has more or less risk than the firm’s average level of risk

  3. Risk • Project risk • The risk that a project will perform below expectations • Some of the risk can be diversified away • Systematic risk • Depends on the risk of the project relative to the market portfolio • Systematic risk cannot be diversified away • Capital Asset Pricing Model • Used to estimate risk-adjusted discount rates for capital budgeting

  4. Adjusting for Total Project Risk • Net Present Value (NPV) - Payback approach • Simulation approach • Sensitivity analysis • Scenario analysis • Risk-adjusted discount rate approach • Certainty equivalent approach

  5. NPV-Payback Approach • A project must have a positive net present value and a payback of less than a critical number of years to be acceptable

  6. Simulation Approach • Estimate the probability distribution of each element influencing a project’s cash flows. • Calculate the NPV using randomly chosen numerical values for the stochastic elements • Repeat the process until a probability distribution of the NPV can be estimated • Possible stochastic elements: • Number of units sold, market price, net investment, unit production costs, unit selling cost, project life, cost of capital

  7. Sensitivity Analysis • Involves systematically changing relevant variables to identify which variables the NPV/IRR seems most sensitive to • Useful to make sensitivity curves to show the impact of changes in a variable on the project’s NPV • Electronic spreadsheets and financial modeling make sensitivity analysis easy to perform.

  8. Scenario Analysis • Estimate the expected NPV for each of: • Optimistic • Pessimistic • Most likely • Estimate the Probability of each scenario • Compute the expected NPV • Compute the standard deviation (SD) of the NPV • Considers the impact of simultaneous changes in key variables on the desirability of an investment project

  9. Risk-Adjusted Discount Rate Approach • An individual project is discounted at a discount rate adjusted to the riskiness of the project instead of discounting all projects at one rate • ka* = rf + risk premium • Calculate the NPV substituting ka* for k in the six steps of capital budgeting

  10. Certainty Equivalent Approach • Involves converting expected risky Cash Flows to their certainty equivalents and then computing the NPV • Risk-free rate (rf) is used as the discount rate rather than the cost of capital (k) • The certainty equivalent factor is the ratio of the certainty equivalent Cash Flows to the risky Cash Flows

  11. = Certainty equivalent factor for net investment at t=0 n = Expected economic life of the project = Certainty equivalent factor for expected net cash flows in each period, t rf = risk free rate The Certainty-Equivalent NPV

  12. Elements of Risk if Investing Abroad • Captive funds – inability to repatriate • Foreign government expropriates the assets • Exchange rate risk • Uncertain tax rates

  13. Calculating k: All Equity Case • The project’s risk-adjusted discount rate is found using the security market line (SML) equation:

  14. The Equity and Debt Case • Betas can be observed for firms in the same investment class as the proposed investment • These betas can be used to estimate risk-adjusted discount rates • A two-step process is used • Calculate an unleveraged beta • Calculate a new leveraged beta to reflect appropriate debt capacity

  15. Step 1: Calculate Unleveraged Beta • Convert observed, leveraged beta (l) into an unleveraged, or pure project beta (u) T = Firm’s marginal tax rate D = Market value of firm’s debt E = Market value of firm’s equity

  16. Step 2: Calculate New Leveraged Beta • Calculate the new leveraged beta (l)for the proposed capital structure of the new line of business

  17. Step 2 (Continued) • Calculate the required rate of return, ke, based on the new leveraged beta, l: • Calculate the risk-adjusted required return, ka*, on the new line of business:

  18. Major Points • Adjust for project risk using any one of six methods • Net Present Value (NPV) -Payback approach • Simulation approach • Sensitivity analysis • Scenario analysis • Risk-adjusted discount rate approach • Certainty equivalent approach

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