Chapter 2 - Capital Budgeting Under Risk
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This document discusses methods for incorporating risk into capital budgeting analysis. It covers
expected values, expected net present value (ENPV), sensitivity analysis, scenario analysis, and certainty
equivalents. Sensitivity analysis assesses the impact of different cash flow estimates on NPV. Scenario
analysis evaluates the impact of simultaneous changes to multiple variables. Certainty equivalents
represent the certain cash flow an investor would require instead of risky cash flows. The example
shows adjusting two projects' cash flows using certainty equivalents and recalculating NPV to account
for differing risk levels.
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Chapter 2 - Capital budgeting under risk
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Methods of incorporating risk in capital budgetingExpected cash flows and expected net present
valueUnder conditions of uncertainty, a separate probability distribution is used to summarizethe
possible net investments or cash flows for each year. The first step in evaluating thedesirability of risky
projects is to compute the expected value of each probabilitydistribution. This is obtained by multiplying
each possible cash value by its probability of occurrence and adding the resulting [Link]: is the
possible cash value I for a given yearis probability of occurrence of fi E is t he expected valueExample:
expected value of cash flows and probability distributions are as follows:Cash flow ProbabilityYear 1
2000 0.34000 0.46000 0.3Year 2 1000 0.13000 0.57000 0.4E1= 0.3x2000+0.4x4000+0.3x6000=4000 E2=
0.1x1000+0.5x3000+0.4x7000=4400Expected Net present Value (ENPV)The expected net present value
of a capital budgeting alternatives, ENPV, is computed asfollows. Let k* represent the risk free rate of
return, then:∑ Et (1+k)tExamplePossible net investmentProbability(4000)0.3(5000)0.4(6000)0.3The
bracket (negative) values indicate that a net investment is a cash outflow. This probability distribution
has an expected value of (5000) EtYear 0(5000)Year 14000Year 24400
________________________________________________________________________ Capital
Budgeting under risk 1
Chapter 2 – Capital budgeng under risk
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If the risk free rate of return is 8 percent, the NPV statistics for this project are calculatedas follows. The
expected NPV is computed as follows:ENPV = -5000 + 4000 + 4400 (1+.08)0
(1+.08)1(1+.08)2=2,076Sensitivity and Scenario analysisTwo approaches for dealing with project risk is
to capture the variability of cash inflowsand NPV are Sensitivity and Scenario [Link]
analysisIs a behavioral approach that uses a number of possible values for a given variable, suchas cash
inflows, to assess its impact on the firm’s return, measured by NPV. In capital budgeting, one of the
most common sensitivity approaches is to estimate the NPVassociated with pessimistic, most likely, and
optimistic cash inflow estimates. Bysubtracting the pessimistic outcome NPV from the optimistic
outcome NPV, the rangecan be [Link]:Assume ABC Company’s manager made pessimistic,
most likely and optimisticestimates of the cash inflows for each project. The cash inflow estimates and
resulting NPV’s in each case are summarized as follows:Sensitivity analysis of ABC’s Project X and Y,
Project XProject YInitial investmentBr. 10,000Br.10,000Annual Cash
inflowsOutcomePessimistic15000Most likely20002000Optimistic25004000Range10004000 Net present
ValuesOutcomePessimistic1409-10,000Most likely52125212Optimistic901520424Range760630424The
values were calculated by using the corresponding annual cash inflows. A 10% costof capital and a 15
years life for the annual cash flows were used. Comparing the rangesof cash inflows (br. 1000 for project
X) and 4000 for project Y) and more important theranges of NPVs (br 7606 for project X and Br 30424 for
project Y) make it clear that project X is less risky than project Y. Given that both projects have the same
most likely NPV of br 5212, the assumed risk averse decision maker will take project X because ithas less
risk and no possibility of [Link] analysis, which is a behavioral approach similar to sensitivity
analysis but broader in scope is used to evaluate the impact of various circumstances on the firm’s
________________________________________________________________________ Capital
Budgeting under risk 2
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return. Rather than isolating the effect of a change in a single variable, scenario analysisis used to
evaluate the impact on return of simultaneous change in a number of variablessuch as cash inflows and
the cost of capital resulting from differing assumptions relativeto economic and competitive conditions.
For example, the firm could evaluate the impactof both high inflation (scenario 1) no inflation (scenario
2) on a projects NPV. Eachscenario will affect the firm’s cash inflows, cash outflows and cost of capital
therebyresulting in different levels of NPV. The decision maker can use these NPV estimates toroughly
assess the risk involved in respect the level of inflation. Certainty EquivalentOne of the most direct and
theoretically preferred approaches for risk adjustment is theuse of certainty equivalents which
represents the percent of estimated cash inflow thatinvestors would be satisfied to receive forcertain
rather than the cash inflows that are possible for each year. The basic expression for NPV when certainty
equivalents are usedfor risk adjustment is as follows:∑ (et
)xCFt (1+R f )Where: et is certainty equivalent factor in year (et is between 0 &1) CFtis relevant cash
inflow in year t R f is the risk free rate of returnThe equation shows that the project is adjusted for risk
by first converting the expectedcash inflows to certain amounts, (et X CFt) and discounting the cash
inflows at [Link] ABC company wishes to consider risk in the analysis of two projects A and [Link]
cost of capital is 10% when considering risk. The project cash flows are as [Link] AProject
BInitial investmentBr. 42,000Br. 45,000Cash
flows114,00028,000214,00012,000314,00010,000414,00010,000514,00010,000By ignoring risk
differences and using NPV at 10% cost of capital, project A is preferredover project B since its NPV of br.
11,074 is greater than B’s NPV of birr 10,[Link] however, that on further analysis the firm found
that project A is actually morerisky than project B, to consider the deferring risks; the firm estimated the
certainty ________________________________________________________________________
Capital Budgeting under risk 3
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equivalent factors for each project’s cash inflows for each year. Certainty equivalent for project A and B
are as follows:YearProject AProject B10.901.0020.900.9030.800.9040.700.8050.600.70Upon
investigation, ABC’s management estimated the prevailing risk free rate of return,Rf, to be 6
[Link]: calculate the [Link] AYearCashflowCertainty equivalent factorCertainty
cashinflowsPresent value114,0000.9012,600X(1.06)-1= 11,882214,0000.9012,600X(1.06)-2=
11,214314,0000.8011,200X(1.06)-3= 9,408414,0000.709,800X(1.06)-4= 7,762514,0000.608,400X(1.06)-
5= 6,275Present value of cash inflows = 46,541Less: initial investment = 42,000NPV= 4,541Project
BYearCashflowCertainty equivalent factorCertainty cashinflowsPresent value128,0001.0028,000X(1.06)-
1= 26,404212,0000.9010,800X(1.06)-2= 9612310,0000.909,000X(1.06)-3=
7560410,0000.808,000X(1.06)-4= 6336510,0000.707,000X(1.06)-5= 5229Present value of cash inflows =
55141 ________________________________________________________________________ Capital
Budgeting under risk 4
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Less: initial investment = 45,00NPV= 10,141 Note that as a result of the risk adjustment, project B is
now preferred. The usefulness of the certainty equivalent approach for risk adjustment should be quite
clear, the onlydifficulty lies in the need to make subjective estimates of the certainty equivalent
[Link] for inflationSo far, the effect of inflation has not been considered on the appraisal of
capitalinvestment proposals. Inflation is particularly important in developing countries as therate of
inflation tends to be rather high. As inflation rate increases, so will the minimumreturn required by an
investor. For example, one might be happy with a return of 10%with zero inflation, but if inflation was
20%, one would expect a much greater [Link] Farm is considering investing in a project
with the following cash flows:TIMEACTUAL CASH FLOWS$0(100,000)190,000280,000370,000Keymer
Farm requires a minimum return of 40% under the present conditions. Inflationis currently running at
30% a year and this is expected to continue indefinitely. ShouldKeymer Farm go ahead with the project?
Let us take a look at Keymer Farm’s required rate of return. If it invest $10,000 for oneyear on 1 January,
then on 31 December it would required a minimum return of $4,[Link] the initial investment of
$10,000, the total value of the investment by 31 December must increase to $14,000. During the year,
the purchasing value of the dollar would falldue to inflation. We can restate the amount received on 31
December in terms of the purchasing power of the dollar at 1 January as follows:Amount received on 31
December in terms of the value of the dollar at 1 January:= $14,000 (1.30)1
________________________________________________________________________ Capital
Budgeting under risk 5
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= $10,769In terms of the value of the dollar at 1 January, Keymer Fram would make a profit of $769
which represents a rate of return of 7.69% in “today’s money” terms. This is knowsas the real rate of
return. The required rate of 40% is a money rate of return (sometimesknown as a nominal rate of
return). The money rate measures the return in terms of thedollar, which is falling in value. The real rate
measures the return in constant price [Link] two rates of return and the inflation rate are
linked by the equation:(1+ money rate)= (1 + real rate)x (1 + inflation rate)Where all the rates are
expressed as [Link] the example,(1+0.40)= (1+0.0769) x (1+0.3)=1.40So, which rate is used in
discounting? As a rule of thumb:a)If the cash flows are expressed in terms of actual dollars that will be
received or paid in the future, the money rate for discounting should be used. b)If the cash flows are
expressed in terms of the value of the dollar at time 0 (i.e. inconstant price level terms), the real rate of
discounting should be [Link] Keymer Farm’s case, the cash flows are expressed in terms of the actual
dollars thatwill be received or paid at the relevant dates. Therefore, we should discount them usingthe
money rate of [Link] CASH FLOW DISOCUNT FACTOR PV$40%
$0(100,000)1.000(100,000)190,0000.71464,260280,0000.51040,800370,0000.36425,48030,540The
project has a positive net present value of $30,540, so Keymer Farm should go aheadwith the project.
The future cash flows can be re-expressed in terms of the value of thedollar at time 0 as follows, given
inflation at 30% a year.
________________________________________________________________________ Capital
Budgeting under risk 6
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