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Chapter 11: Capital Budgeting and Risk AnalysisPowerPoint Presentation

Chapter 11: Capital Budgeting and Risk Analysis

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Chapter 11:Capital Budgeting and Risk Analysis

2002, Prentice Hall, Inc.

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 RiskAlone 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 RiskAlone 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 RiskAlone 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 RiskIncorporating Risk into Capital Budgeting

Two Methods:

- Certainty Equivalent Approach
- Risk-Adjusted Discount Rate

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.

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

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.

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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