CH 11

Capital Budgeting and Risk Analysis

Three Measures of a Projects Risk

Project Standing Alone Risk Risk diversified away within firm as this project is combined with firms other projects and assets.

Projects Contributionto-Firm Risk

Systematic Risk

Risk diversified away by shareholders as securities are combined to form diversified portfolio.

Incorporating Risk into Capital Budgeting

Two Approaches
Certainty Equivalent Approach
Adjust free cash flows (FCF) Use risk-free rate to discount CFs

Risk-Adjusted Discount
Rate
Adjust discounting rate

 Adjusts the risky after-tax cash flows

to certain cash flows. The idea: Risky Cash Flow Certainty Equivalent Factor (a) Certain = Cash Flow

Certainty Equivalent Approach

Certainty Equivalent Approach

Risky Cash X Flow Risky $1000 Risky $1000 Certainty Equivalent Factor (a) .70 = Certain Cash Flow safe $700 safe $950

.95

 The greater the risk associated

with a particular cash flow, the smaller the CE factor.

Certainty Equivalent Method

n

NPV =

t=1

FCFt - IO t (1 + krf)
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 Approach

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 riskadjusted discount rate.

Risk-Adjusted Discount Rate

n

NPV =

t=1

FCFt t - IO (1 + k*)

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*) 1 12% 2 3 4 14% 16% 24% Project Type Replace equipment, Expand current business Related new products Unrelated new products Research & Development

Yr 0 1 2 3 4 5 6 7 8 9 10

Risk Adjusted Approach FCF(t) PV at 0.15 PV of FCF(t) -800000 1.0000 -800000 100000 0.8696 86957 100000 0.7561 75614 100000 0.6575 65752 100000 0.5718 57175 100000 0.4972 49718 100000 0.4323 43233 100000 0.3759 37594 100000 0.3269 32690 100000 0.2843 28426 100000 0.2472 24718 NPV (298,123.14)

Yr 0 1 2 3 4 5 6 7 8 9 10

CE Approach (w/o alpha) FCF(t) PV at 0.06 PV of FCF(t) -800000 1.0000 -800000 100000 0.9434 94340 100000 0.8900 89000 100000 0.8396 83962 100000 0.7921 79209 100000 0.7473 74726 100000 0.7050 70496 100000 0.6651 66506 100000 0.6274 62741 100000 0.5919 59190 100000 0.5584 55839 NPV (63,991.29)

RAA approach implies that risk becomes greater as cash flows are further away. Reducing alpha indicates that risk is greater. (Alpha = 1 = Sure thing!

Yr 0 1 2 3 4 5 6 7 8 9 10

FCF(t) -800000 100000 100000 100000 100000 100000 100000 100000 100000 100000 100000

CE Approach (with alpha) Alpha PV at 0.06 PV of FCF(t) 1.0000 -800000 0.92 0.9434 86957 0.85 0.8900 75614 0.78 0.8396 65752 0.72 0.7921 57175 0.67 0.7473 49718 0.61 0.7050 43233 0.57 0.6651 37594 0.52 0.6274 32690 0.48 0.5919 28426 0.44 0.5584 24718 NPV (298,123.14)