CH 11

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# CH 11 - PowerPoint PPT Presentation

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

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

to form diversified

portfolio.

Systematic Risk

Three Measures of a Project’s Risk
Certainty Equivalent Approach

Use risk-free rate to discount CFs

Incorporating Risk into Capital Budgeting

Two Approaches

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

Risky “safe”

\$1000 .95 \$950

n

t=1

t FCFt

(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

• 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

FCFt

(1 + k*)

NPV = - IO

t

• 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

Class (k*) Project Type

1 12% Replace equipment,