RISK

Risk is defined as the potential variability in future cash flow

THREE TYPES OF A PROJECT’S RISK

Project Standing Alone Risk

Project contribution to firm risk

Systemati c risk

the risk of a project standing alone is measured by the variability of the asset’s expected returns. and the firm’s stock is but one of many stocks within a stockholder’s portfolio. .PROJECT STANDING ALONE RISK The risk of a project ignoring the fact that it is only one of many projects within the firm.

but ignoring the effects of shareholder diversification within the portfolio. . it is a project’s risk considering the effects of diversification among different projects within the firm. That is.PROJECT’S CONTRIBUTION TO FIRM RISK the amount of risk that a project contributes to the firm as a whole.

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

perspective Project standing alone: ignores diversification within the firm and within the shareholder’s portfolio Project from the company’s perspective: ignores diversification within the shareholder’s 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 firm’s other projects and assets Risk diversified away by shareholders as securities are combined to form diversified portfolio Project from the shareholder’s perspective : allows for diversification within the firm and within the shareholder’s portfolio Systematic risk .

Risk-Adjusted Discount Rate .Certainty Equivalent Approach .Incorporating Risk into Capital Budgeting Two Methods: .

How can we adjust this model to take risk into account? NPV = S t=1 n ACFt .IO (1 + k)t .

-The idea: Risky Cash Flow x Certainty Equivalent Factor (a) = Certain Cash Flow .Adjusts the risky after-tax cash flows to certain cash flows.Certainty Equivalent Approach .

Certainty Equivalent Method NPV = S t=1 n ACFt .IO (1 + krf)t t .

2) Discount the certain cash flows by the risk-free rate of interest.Certainty Equivalent Approach Steps: 1) Adjust all after-tax cash flows by certainty equivalent factors to get certain cash flows. .

IO .Risk-Adjusted Discount Rate NPV = S t=1 n ACFt t (1 + k*) .

.Many firms set up risk classes to categorize different types of projects.How do we determine the appropriate risk-adjusted discount rate (k*) to use? Risk-Adjusted Discount Rates ..

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. .

Develop probability distributions for key factors  2.4 STEPS FOR DOING SIMULATION APPROACH 1. investment required. Randomly selecting observations from each of the distributions that affect the outcome of project ( Market size.  . selling price. operating cost. useful life of facilities). market growth rate. fixed cost. Continuing this process until a clear portrait of the results is obtained.  3. share of market. residual value of investment. Combining those observation to determine final output of the project  4.

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  .

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

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 firm’s required rate of return because the project required rate of return has not yet been adjusted for the risk.PROBABILITY TREES    Probability Trees is graphic exposition of the sequence of possible outcomes. and can only be applied to situations where more than one observation can be occurred at the same time. . Joint probability is a measure of two events happening at the same time.

000 flow in year 1 and $ 300. Two branches would be sent out from the outcome 1 node.000 flow is multiplied by the conditional probability of the second flow. the probability of the $ 600.For example.  .000 cash flow and an 80 percent chance of a $ 600.  Finally. then there would be a 20 percent chance of a $ 300.000 cash flow in year 2.000 outcome in year 2. if outcome 1 occurs in year 1. telling us that this sequence has a 10 percent chance of occurring. reflecting these two possible outcomes. to determine the probability of sequence of a $ 600.

5 $ 600.000 ( Outcome 3 ) . Initial Outlay : .000.1.000 P : 0.3 $ 700.000 ( Outcome 2 ) P : 0.2 $ 800.000 ( Outcome 1 ) IO P : 0.

2 $ 700.8 2 years $ 300.000 P: 0.000 P: 0.3 P: 0.000 $ 400.3 $ 700.000 .000 P: 0.000 $ 600.2 P: 0.1 $ 800.2 P: 0.000 $ 500.000.000 $ 600.Time O years 1 years P: 0.000 P: 0.$ 1.2 $ 800.000 $ 300.000 P: 0.5 P: 0.000 $ 600.7 P: 0.5 .

98 0. 07 0.8052 0.7.8535 0. 83 27.90 0.06 0.15 0.2510 25. 18 37.00 3.5932 3.7596 Expected Internal Rate of Return : 14. 69 14.000 1.2 1.04 0. 55 13.0.10 0.40 0. 7550 5.Internal Rate of Return Joint Probability ( B ) for each branch ( A ) .14 0.09 (A)x(B) .2280 0.00 13.7355 % .

For Example. Cash flows of year two is dependent with cash flows of year one so it is called time dependency of cash flows.  . 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.TIME DEPENDENCE OF CASH FLOWS  In any project.

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