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CH 11

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knoton
14 diapositives · 322 Views · Oct 20, 2014

CH 11. Capital Budgeting and Risk Analysis. 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

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CH 11
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  1. CH 11 Capital Budgeting and Risk Analysis

  2. 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

  3. Certainty Equivalent Approach Adjust free cash flows (FCF) Use risk-free rate to discount CFs Risk-Adjusted Discount Rate Adjust discounting rate Incorporating Risk into Capital Budgeting Two Approaches

  4. 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

  5. Certainty Equivalent Approach Risky Certainty Certain Cash X Equivalent = Cash Flow Factor (a) Flow Risky “safe” $1000 .70 $700 Risky “safe” $1000 .95 $950

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

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

  8. 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.

  9. Incorporating Risk into Capital Budgeting Risk-Adjusted Discount Rate Approach

  10. 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.

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

  12. 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.

  13. 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

  14. RAA approach implies that risk becomes greater as cash flows are further away. Reducing alpha indicates that risk is greater. (Alpha = 1 = Sure thing!