Chapter 11 capital budgeting and risk analysis
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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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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

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

Project’s

contribution-

to-firm 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

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


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


Incorporating Risk into Capital Budgeting

Two Methods:

  • Certainty Equivalent Approach

  • Risk-Adjusted Discount Rate


n

t=1

S

ACFt

(1 + k)

NPV = - IO

t

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


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).


Certainty Equivalent Approach

  • Adjusts the risky after-tax cash flows to certain cash flows.

  • The idea:


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


Certainty Equivalent Approach

Risky Certainty Certain

Cash X Equivalent = Cash

Flow Factor (a) Flow

Risky “safe”

$1000 .70 $700


Certainty Equivalent Approach

Risky Certainty Certain

Cash X Equivalent = Cash

Flow Factor (a) Flow

Risky “safe”

$1000 .95 $950


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


n

t=1

t ACFt

(1 + krf)

NPV = - IO

Certainty Equivalent Method

S

t


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.


Incorporating Risk into Capital Budgeting

  • Risk-Adjusted Discount Rate


n

t=1

S

ACFt

(1 + k)

NPV = - IO

t

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


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).


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.


n

t=1

S

ACFt

(1 + k*)

NPV = - IO

t

Risk-Adjusted Discount Rate


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.


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


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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