Chapter 11:

Capital Budgeting and

Risk Analysis

Ê
 

  
 6ncorporating Risk into
Capital Budgeting

Ô


’ Certainty Equivalent Approach
’ Risk
Risk--Adjusted Discount Rate
 ow can we adjust this model to
take risk into account?
n
ACFt
NPV =
t=1
(1 + k) t - 6
 ow can we adjust this model to
take risk into account?
n
ACFt
NPV =
t=1
(1 + k) t - 6

’ Adjust the After-

After-tax Cash Flows (ACFs),
or
’ Adjust the discount rate (k).
 Certainty Equivalent Approach
’ Adjusts the risky after
after--tax cash flows
to certain cash flows.
’ The idea:
 Certainty Equivalent Approach
’ Adjusts the risky after
after--tax cash flows
to certain cash flows.
’ The idea:

Risky Certainty Certain

Cash X Equivalent = Cash
Flow Factor (a) Flow
 Certainty Equivalent Approach

Risky Certainty Certain

Cash X Equivalent = Cash
Flow Factor (a) Flow

Risky ³safe´
$1000 .70 $700
 Certainty Equivalent Approach

Risky Certainty Certain

Cash X Equivalent = Cash
Flow Factor (a) Flow

Risky ³safe´
$1000 .95 $950
’ The greater the risk
associated with a particular
cash flow, the smaller the CE
factor.
 Certainty Equivalent Method

n
t ACFt
NPV =

t=1
(1 + krf)t - 6
 Certainty Equivalent Approach

’ Steps:
1) Adjust all after-
after-tax cash flows by
certainty equivalent factors to get
certain cash flows.

2) Discount the certain cash flows by

the risk
risk--free rate of interest.
 Risk--Adjusted Discount Rate
Risk

’ Simply adjust the discount rate (k)

to reflect higher risk.
’ Riskier projects will use higher
risk--adjusted discount rates.
risk
’ Calculate NPV using the new risk-
risk-
adjusted discount rate.
 Risk--Adjusted Discount Rate
Risk

n
ACFt
NPV =

t=1
(1 + k*) t - 6
 Risk--Adjusted Discount Rates
Risk

’ ow do we determine the appropriate

risk--adjusted discount rate (k*) to use?
risk
’ 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 after-
after-tax cash flows
(certainty equivalent method), or
’ Adjusting the discount rate used (risk
(risk--
adjusted discount rate method).
’ Computer simulation methods.