RISK

Risk is defined as the potential variability in future cash flow

THREE TYPES OF A PROJECTS RISK

Project Standing Alone Risk

Project contribution to firm risk

Systemati c risk

PROJECT STANDING ALONE RISK

The risk of a project ignoring the fact that it is only one of many projects within the firm, and the firms stock is but one of many stocks within a stockholders portfolio. the risk of a project standing alone is measured by the variability of the assets expected returns.

PROJECTS CONTRIBUTION TO FIRM RISK

the amount of risk that a project contributes to the firm as a whole. That is, it is a projects risk considering the effects of diversification among different projects within the firm, but ignoring the effects of shareholder diversification within the portfolio.

SYSTEMATIC RISK
the risk of a project measured from the point of view of a well diversified shareholder. That is, it is a projects risk taking into account the fact that this project is only one of many projects within the firm, and the firms stock is but one of many stocks within a stockholders portfolio

perspective Project standing alone: ignores diversification within the firm and within the shareholders portfolio Project from the companys perspective: ignores diversification within the shareholders portfolio, but allows for diversification within the firm

measures Project standing alone risk

Project contribution to firm risk

firm Risk diversified away within firm as this project is combined with the firms other projects and assets
Risk diversified away by shareholders as securities are combined to form diversified portfolio

Project from the shareholders perspective : allows for diversification within the firm and within the shareholders portfolio

Systematic risk

Incorporating Risk into Capital Budgeting

Two Methods: - Certainty Equivalent Approach - Risk-Adjusted Discount Rate

How can we adjust this model to take risk into account?

NPV =

S
t=1

ACFt - IO (1 + k)t

Certainty Equivalent Approach

- 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 Method

NPV =

S
t=1

ACFt - IO (1 + krf)t
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.

Risk-Adjusted Discount Rate

NPV =

S
t=1

ACFt t (1 + k*)

- IO

- How do we determine the appropriate risk-adjusted discount rate (k*) to use?

Risk-Adjusted Discount Rates

- Many firms set up risk classes to categorize different types of projects.

3 APPROACH TO EVALUATING RISK IN

CAPITAL BUDGETING

SIMULATION

Simulation is the process of imitating the performance of an investment project under evaluation using computer.

4 STEPS FOR DOING SIMULATION APPROACH

1. Develop probability distributions for key factors 2. Randomly selecting observations from each of the distributions that affect the outcome of project ( Market size, selling price, fixed cost, market growth rate, investment required, residual value of investment, share of market, operating cost, useful life of facilities). 3. Combining those observation to determine final output of the project 4. Continuing this process until a clear portrait of the results is obtained.

SENSITIVITY ANALYSIS
The process of determining how the distribution of possible returns for a particular project is affected by a change in one particular input variable. This is done by changing the value of one input variable while holding all other input variables constant

FOR EXAMPLE, IN ANALYZING THE PROPOSAL FOR A NEW DRUG FOR THE TREATMENT OF ALZEIMERS DISEASE, MERCKS
MANAGEMENT MAY WISH TO DETERMINE THE EFFECT OF A MORE PESSIMISTIC FORECAST OF THE ANTICIPATED MARKET GROWTH RATE. AFTER THE MORE PESSIMISTIC FORECAST REPLACES THE ORIGINAL FORECAST IN THE MODEL, THE SIMULATION IS RETURN. THE TWO OUTPUTS ARE THEN COMPARED TO DETERMINE HOW SENSITIVE THE RESULT OF THE MARKET GROWTH RATE.

PROBABILITY TREES

Probability Trees is graphic exposition of the sequence of possible outcomes. It presents the decision maker with a schematic representation of the problem in which all possible outcomes are pictured Decision making with probability trees does not mean simply the acceptance of any project with an internal rate of return greater than the firms required rate of return because the project required rate of return has not yet been adjusted for the risk. Joint probability is a measure of two events happening at the same time, and can only be applied to situations where more than one observation can be occurred at the same time.

For example, if outcome 1 occurs in year 1, then there would be a 20 percent chance of a $ 300.000 cash flow and an 80 percent chance of a $ 600.000 cash flow in year 2. Two branches would be sent out from the outcome 1 node, reflecting these two possible outcomes. Finally, to determine the probability of sequence of a $ 600.000 flow in year 1 and $ 300.000 outcome in year 2, the probability of the $ 600.000 flow is multiplied by the conditional probability of the second flow, telling us that this sequence has a 10 percent chance of occurring.

Initial Outlay : - 1.000.000

P : 0,5

$ 600.000 ( Outcome 1 )

IO

P : 0,3

$ 700.000 ( Outcome 2 )

P : 0,2

$ 800.000 ( Outcome 3 )

Time O years 1 years P: 0,2 P: 0,5 - $ 1.000.000 $ 600.000 P: 0,8 2 years $ 300.000 $ 600.000 $ 300.000 $ 500.000 P: 0,5 P: 0,2 P: 0,2 $ 700.000 $ 400.000 $ 600.000 P: 0,7 P: 0,3

P: 0,3
$ 700.000

P: 0,2

$ 800.000

P: 0,1

$ 800.000

Internal Rate of Return Joint Probability ( B ) for each branch ( A ) - 7, 55 13, 07 0,00 13,90 0,10 0,40 0,06 0,09

(A)x(B)

- 0, 7550 5,2280 0,000 1,2510

25, 69
14, 83 27, 18 37, 98

0,15
0,04 0,14 0,2 1,00

3,8535
0,5932 3,8052 0,7596

Expected Internal Rate of Return : 14,7355 %

TIME DEPENDENCE OF CASH FLOWS

In any project, Cash flows of year two is dependent with cash flows of year one so it is called time dependency of cash flows. For Example, if a new product is introduced and the initial public reaction is poor, resulting in low initial cash flows, then cash flows in future periods are likely to be low.