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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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ch 11

CH 11

Capital Budgeting and Risk Analysis

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
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

certainty equivalent approach
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 approach1
Certainty Equivalent Approach

Risky Certainty Certain

Cash X Equivalent = Cash

Flow Factor (a) Flow

Risky “safe”

$1000 .70 $700

Risky “safe”

$1000 .95 $950

certainty equivalent method

n

t=1

t FCFt

(1 + krf)

NPV = - IO

Certainty Equivalent Method

S

t

certainty equivalent approach2
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 budgeting1
Incorporating Risk into Capital Budgeting

Risk-Adjusted Discount Rate Approach

risk adjusted discount rate
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 rate1

n

t=1

S

FCFt

(1 + k*)

NPV = - IO

t

Risk-Adjusted Discount Rate
risk adjusted discount rates
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 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

slide14

RAA approach implies that risk becomes greater as cash flows are further away.

Reducing alpha indicates that risk is greater.

(Alpha = 1 = Sure thing!