Chapter 10

Capital Budgeting and Risk

Copyright 2003 South-Western/Thomson Learning

Introduction
This chapter looks at adjusting a
projects risk level when it has more
or less than the firms average risk
level.
Risk
Project risk
Project risk is the risk that a project will
perform below expectations.
Some of the risk can be diversified away.
Beta risk
Beta risk depends on the risk of the project
relative to the market-portfolio.
Beta (systematic) risk cannot be diversified
away.
Capital asset pricing model (CAPM)
The CAPM is used to estimate risk-adjusted
Information on Risk
The Society for Risk Analysis (SRA)
http://www.sra.org/index.htm

Official journal of the SRA is Risk

Analysis
http://www.sra.org/journal.htm
Adjusting for Beta Risk in Capital
Budgeting
The beta concept introduced in Chapter
5 for security risk analysis can also be
used to determine risk-adjusted discount
rates (RADR) for individual capital
budgeting projects. This approach is
appropriate for a firm whose stock is
widely traded and for which there is very
little chance of bankruptcy.
The probability of bankruptcy is a function of
total risk, not just systematic risk.
Adjusting for Beta Risk in Capital
Budgeting
Just as the beta (systematic risk) of a
portfolio of securities can be computed
as the weighted average of the
individual security betas, a firm may be
considered as a portfolio of assets, each
having its own beta. From this
perspective, the systematic risk of the
firm is simply the weighted average of
the systematic risk of the individual
assets.
All Equity Case
The projects risk-adjusted discount rate
is found with the SML equation:
k rf (rm rf )
*
e
All Equity Case: Example
For example, consider the security
market line shown in Figure 10.4. The
firm has a beta of 1.2 and is financed
exclusively with internally generated
equity capital. The market risk premium
is 7 percent.
All Equity Case: Example
When considering projects of average
riskthat is, projects that are highly
correlated with the firms returns on its
existing assets and that have a beta
similar to the firms beta (1.2)the firm
should use the computed 13.4 percent
cost of equity from Figure 10.4.
All Equity Case: Example
When considering projects having
estimated beta different from 1.2, it
should use an equity discount rate equal
to the required rate of return calculated
from the security market line.
All Equity Case: Example
For example, if a projects estimated
beta is 1.7 and the risk-free rate is 5
percent, the projects required rate of
return would be 16.9 percent and this
would be used as the risk-adjusted
discount rate for that project, assuming
the project is finance with 100 percent
equity.
The Equity and Debt Case
To better understand the material in this
section, we briefly introduce the concept
of a weighted (average) cost of capital,
which is developed more extensive in
Chapter 11.
The Equity and Debt Case
At this point, it is only necessary to
recognize that the required return on the
project discussed in this section reflects
the projects equity return requirement
and the debt return requirement for the
funds expected to be used to finance the
project.
The Equity and Debt Case
Consider the example of Vulcan
Industries, with a current capital
structure consisting of 50 percent debt
and 50 percent equity. Vulcan is
considering expanding into a new line of
business and wants to compute the rate
of return that will be required on projects
in this area.
The Equity and Debt Case
Vulcan has determined that the debt
capacity associated with projects in its
new business line is such that a capital
structure consisting of 40 percent debt
and 60 percent common equity is
appropriate to finance these new
projects.
The Equity and Debt Case
Vulcans company beta has been
estimated to be 1.3, but the Vulcan
management does not believe that this
beta risk is appropriate for the new
business line. Vulcans managers must
estimate the beta risk appropriate for
projects in this new line of business and
then determine the risk-adjusted return
requirement on these projects.
The Equity and Debt Case
Because the beta risk of projects in this
new business line is not directly
observable, Vulcans managers have
decided to rely on surrogate market
information. They have identified a firm,
Olympic Materials, that competes
exclusively in the line of business into
which Vulcan proposes expanding. The
beta of Olympic has been estimated to
be 1.5.
The Equity and Debt Case
Recall from Chapter 5 that a firms beta
is computed as the slope of its
characteristic line and that actual
security returns are used in the
computations. Accordingly, a firms
computed beta is a measure of both its
business risk and its financial risk. When
a beta is computed for a firm such as
Olympic, it reflects both the business
and financial risk of that firm.
The Equity and Debt Case
To determine the beta associated with
Vulcans proposed new line of business
using the observed beta from another
firm (Olympic) that competes exclusively
in that business line, it is necessary to
convert the observed beta, often called a
leveraged beta, l, into an unleveraged,
or pure project beta, u.
The Equity and Debt Case
This unleveraged beta can then be
releveraged to reflect the amount of debt
capacity appropriate for this type of
project and that will be used by Vulcan
to finance it.
The Equity and Debt Case:
Summary
Betas can be observed for firms in the
same investment class as the
proposed investment.
These betas can be used to estimate
risk-adjusted discount rates.
A two-step process is used:
1. Calculate an unleveraged beta.
2. Calculate a new leveraged beta to reflect
appropriate debt capacity.
Step 1: Calculate an Unleveraged
Beta
Convert the observed, leveraged beta, l,
into an unleveraged, or pure project beta,
u.
l
u
1 (1 T )( B / E )
where u is the unleveraged beta for a
project or firm, l is the leveraged beta for a
project or firm, B is the market value of the
firms debt, E is the market value of the firms
equity, and T is the firms marginal tax rate.
Step 1: Calculate an Unleveraged
Beta
The use of this equation can be
illustrated for the Vulcan Material
example. The beta, l, for Olympic has
been computed to be 1.50. Olympic has
a capital structure consisting of 20
percent debt and 80 percent common
equity and a tax rate of 35 percent.
Substituting these values into the
equation yields
1.50
u 1.29
1 (1 0.35)(0.25)
Step 2: Calculate a New Leveraged
Beta
Calculate the new leveraged beta, l, for
the proposed capital structure of the new
line of business

l u [1 (1 T )( B / E )]
Step 2: Calculate a New Leveraged
Beta
The unleveraged, or pure project beta
for the proposed new line of business of
Vulcan is estimated to be 1.29. Vulcan
intends to finance this new line of
business with a capital structure
consisting of 40 percent debt and 60
percent common equity. In addition,
Vulcans tax rate is 40 percent.
Step 2: Calculate a New Leveraged
Beta
The equation can be rearranged to
compute the leveraged beta associated
with this new line of business, given
Vulcans proposed target capital
structure for the project:

l 1.29[1 (1 0.4)(40 / 60)]

1.81
Step 2 Continued
Calculating the required rate of return, ke,
based on the new leveraged beta, l:
k rf (rm rf ) l
*
e

Calculate the risk-adjusted required

return, ka*, on the new line of business:
ka* = %debt(ki) + %equity(ke* )
Step 2 Continued
With a risk-free rate of 5 percent and a
market risk premium of 7 percent, the
required rate of return on the equity
portion of the proposed new line of
business is computed from the security
market line as
ke* = 5% + 7% 1.81 = 17.7%
Step 2 Continued
If the after-tax cost of debt, ki, used to
finance the new line of business is 8
percent, the risk-adjusted required
return, ka*, on the new line of business,
given the proposed capital structure of
40 percent debt and 60 percent equity, is
a weighted average of the marginal,
after-tax debt and equity costs, or
ka* = 0.4(8%) + 0.6(17.7%) = 13.8%
Step 2 Continued
Therefore, the risk-adjusted required
rate of return on the proposed new line
of business for Vulcan is 13.8 percent.
This number reflects about the pure
project risk and the financial risk
associated with the project as Vulcan
anticipates financing it.
Risk-Adjusted Net Present Value
Suppose a company is considering a
project whose net investment is $50,000
with expected cash inflows of $10,000
per year for 10 years. As shown in Table
10.2, the projects NPV is $-1,670 when
evaluate at a risk-adjusted discount rate
(ka*) and $6,500 when evaluated at the
weighted average cost of capital (Ka).
Risk-Adjusted Net Present Value

TABLE 10.2 Calculation of NPV at Weighted Average Cost of

Capital and Risk-Adjusted Discount Rate
Weighted Average Cost of Risk-Adjusted Discount
Capital (ka = 12%) Rate (ka*)
Year t Net Cash Interest Present Interest Present
Flow Factor Value Factor Value
0 $-50,000 1.000 $-50,000 1.000 $-50,000
1-10 10,000 5.650 56,500 4.833 48,330
NPV $6,500 $-1,670
Risk-Adjusted Net Present Value
Assuming that the 16 percent RADR
figure has been determined correctly by
using the security market line with an
accurate beta value, the project should
not be accepted even though its NPV,
calculated using the companys
weighted cost of capital, is positive. This
new product project is similar to Project
4 in Figure 10.5.
Risk-Adjusted Net Present Value
The new product project discussed in
the previous paragraph has an internal
rate of return of about 15 percent,
compared to its 16 percent required
return. Therefore, the project should be
rejected, according to the IRR decision
rule.
Risk-Adjusted Net Present Value
When the IRR technique is used, the
RADR given by the SML frequently is
called the hurdle rate. Some finance
practitioners use the term hurdle rate to
describe any risk-adjusted discount rate.
Risk-Adjusted Net Present Value
Figure 10.5 illustrates the difference
between the use of a single discount
rate, the weighted cost of capital, for all
projects regardless of risk level and a
discount rate based on the security
market line for each project. In the
example in Figure 10.5, Projects 1, 2, 3,
and 4 are being evaluated by the firm.
Risk-Adjusted Net Present Value
Using the weighted cost of capital
approach, the firm would adopt Projects
3 and 4. However, if the firm considered
the differential levels of systematic risk
for the four alternatives, it would accept
Projects 1 and 3 and reject Projects 2
and 4.
Risk-Adjusted Net Present Value
In general, the risk-adjusted discount
rate approach is considered preferable
to the weighted cost of capital approach
when the projects under consideration
differ significantly in their risk
characteristics.
Adjusting for Total Project Risk
The risk adjustment procedures
discussed in this section are appropriate
when the firm believes that a projects
total risk is the relevant risk to consider
in evaluating the project and when it is
assumed that the returns from the
project being considered are highly
correlated with the returns from the firm
as a whole.
Adjusting for Total Project Risk
Therefore, these methods are
appropriate only in the absence of
internal firm diversification benefits,
which might change the firms total risk
(or the systematic portion of total risk).
In addition, total project risk can be
measured by calculating the standard
deviation and coefficient of variation.
These calculations are discussed in
Chapter 5.
Analyze Total Project Risk
NPV-Payback approach
Simulation approach
Sensitivity analysis
Scenario analysis
Risk-adjusted discount rate approach
Certainty equivalent approach
NPV-Payback Approach

Many firms combine net present value

(NPV) and with payback (PB) when
analyzing project risk. As noted in
Chapter 9, the project payback period is
the length of time required to recover
the net investment. Because cash flow
estimates tend to become more
uncertain further into the future,
applying a payback cutoff point can help
reduce this degree of uncertainty.
NPV-Payback Approach
A project must have a positive NPV and
a payback of less than a critical number
of years to be acceptable.
The net present value/payback method
is both simple and inexpensive.
NPV-Payback Approach: Weakness
First, the choice of which payback
criterion should be applied is purely
subjective and not directly related to the
variability of returns from a project.
Some investments may have relatively
certain cash flows far into the future,
whereas others may not. The use of a
single payback cutoff point fails to allow
for this.
NPV-Payback Approach: Weakness
Second, some projects are more risky
than others during their start-up periods;
the payback criterion also fails to
recognize this.
Finally, this approach may cause a firm
to reject some actually acceptable
projects.
NPV-Payback Approach: Strength
This approach is helpful when screening
investment alternatives, particularly
international investments in politically
unstable countries and investments in
products characterized by rapid
technological advances.
NPV-Payback Approach: Strength
Firms that have difficulty raising external
capital and thus are concerned about
the timing of internally generated cash
flows often find a consideration of a
projects payback period to be useful.
Simulation Approach
Estimate the probability distribution of
each element which influences the CFs
of a project.
Elements:
Number of units sold
Market price
Unit production costs
NINV
Unit selling cost
Project life
Cost of capital
Simulation Approach
Calculate the NPV using randomly
chosen numerical values for the
elements.
Repeat the process until a probability
distribution of the NPV can be
estimated.
Simulation Approach
In an actual simulation, the computer
program is run a number of different
times, using different randomly selected
input variables in each instance. Thus,
the program can be said to be repeated,
or iterated, and each run is termed an
iteration. In each iteration, the net
present value for the project would be
computed accordingly. Figure 10.1
illustrates a typical simulation approach.
Simulation Approach
The results of these iterations are then
used to plot a probability distribution of
the projects net present values and to
compute a mean and a standard
deviation of returns. This information
provides the decision maker with an
estimate of a projects expected returns,
as well as its risk. Given this information,
it is possible to compute the probability
of achieving a net present value that is
greater or less than any particular value.
Simulation Approach: Strength
The simulation approach is a powerful
one because it explicitly recognizes all of
the interactions among the variables that
influence a projects net present value. It
provides both a mean net present value
and a standard deviation that can help
the decision maker analyze trade-offs
between risk and expected return.
Simulation Approach: Weakness
The simulation approach can take
considerable time and effort to gather
the information necessary for each of
the input variables and to correctly
formulate the model. This limits the
feasibility of simulation to very large
projects.
Simulation Approach: Weakness
The simulation approach can work only
if the values of the input variables are
independent of one another. If this is not
true, then the simulation must adjust for
the dependence among the input
variables, making the model even more
complexity.
Sensitivity Analysis
Sensitivity analysis is a procedure that
calculates the change in net present
value given a change in one of the cash
flow elements, such as product price. In
other words, a decision maker can
determine how sensitive a projects
return is to change in a particular
variable.
Sensitivity Analysis
Because sensitivity analysis is derived
from the simulation approach, it also
requires the definition of all relevant
variables that influence the net present
value of a project.
The appropriate mathematical
relationships between these variables
must be defined, too, in order to
estimate the cash flow from the project
and compute the net present value.
Sensitivity Analysis
Rather than dealing with the entire
probability distribution for each of the
input variables, however, sensitivity
analysis allows the decision maker to
use only the best estimate of each
variable to compute the net present
value.
Sensitivity Analysis
The decision maker can then ask
various what if questions in which the
projects net present value is
recomputed under various conditions.
Sensitivity Analysis
Sensitivity analysis can be applied to
any variable to determine the effect of
changes in one or more of the inputs on
a projects net present value. This
process provides the decision maker
with a formal mechanism for assessing
the possible consequence of various
scenarios.
Sensitivity Analysis
It is often useful to construct sensitivity
curves to summarize the impact of
changes in different variables on the net
present value of a project. A sensitivity
curve has the projects net present value
on the vertical axis and the variable of
interest on the horizontal axis. For
example, Figure 10.3 shows the
sensitivity curves for two variables, sales
price and cost of capital for a project.
Sensitivity Analysis
The steep slope of the price-NPV curve
indicates that the net present value is
very sensitive to changes in the price for
which the product can be sold.
In contrast, the relatively flat cost-of-
capital-NPV curve indicates that the net
present value is not very sensitive to
changes in the firms cost of capital.
Sensitivity Analysis
Similar curves could be constructed for
project life, salvage value, units sold,
operating costs, and other important
variables.
Sensitivity Analysis
Spreadsheets, such as Excel, have
made the application of sensitivity
analysis techniques simple and
inexpensive. Once the base case has
been defined and entered in the
spreadsheet, it is easy to ask hundreds
of what if questions.
Scenario Analysis
Scenario analysis considers the impact
of simultaneous changes in key
variables on the desirability of an
investment project.
When using the scenario analysis
technique, the financial analyst might
ask the project director to provide
various estimates of the projects
expected net present value.
Scenario Analysis
In addition to what is perceived to be the
most-likely scenario, the project director
might be asked to provide both
optimistic and pessimistic estimates.
Scenario Analysis
An optimistic (pessimistic) scenario
might be defined by the most optimistic
(pessimistic) values of each of the most
input variablesfor example, low (high)
development costs, low (high)
production costs, high (low) prices, and
strong (weak) demand.
Scenario Analysis
The project manager could also be
asked to provide estimates of the
probability that the optimistic scenario
will result and the probability that the
pessimistic scenario will result. With
these probability estimates, the financial
manager can compute an estimate of
the standard deviation of the NPV of the
project.
Risk-Adjusted Discount Rate
Approach
An individual project is discounted at a
discount rate adjusted to the riskiness of
the project instead of discounting all
projects at one rate.

ka* = rf + risk premium

Calculate the NPV substituting ka* for k in

the formula.
Risk-Adjusted Discount Rate
Approach
In the risk-adjusted discount rate
approach, net cash flows for each project
are discounted at a risk-adjusted rate, ka*
to obtain the NPV:
n
NCFt
NPV NINV
t 1 (1 k a )
* t

The magnitude of ka* depends on the

relationship between the total risk of the
individual project and the overall risk of the
firm.
Risk-Adjusted Discount Rate
Approach
When companies assume some amount
of risk, it is expected to earn higher
returns than those available on risk-free
securities. The difference between the
risk-free rate and the firms required rate
of return (cost of capital) is an average
risk premium to compensate investors
for the fact that the companys assets
are risky.
Risk-Adjusted Discount Rate
Approach
This relationship is expressed
algebraically as follows:
= k a rf
is the average risk premium for the firm.
rf is the risk-free rate (the yield on U.S.
government securities, such as 90-day
Treasury bills, is used as the risk-free rate).
ka is the required rate of return for projects
of average risk, that is, the firms cost of
capital.
Risk-Adjusted Discount Rate
Approach
The cash flows from a project having
greater than average risk are discounted
at a higher rate, ka*that is, a risk-
adjusted discount rateto reflect the
increased riskiness.
Certainty Equivalent Approach
The certainty equivalent approach
adjusts the net cash flows in the
numerator of the NPV equation, in
contrast to the RADR approach, which
involves adjustments to the denominator
of the NPV equation.
Certainty Equivalent Approach
A certainty equivalent factor is the ratio
of the amount of cash someone would
require with certainty at a point in time in
order to make him or her indifferent
between that certain amount and an
amount expected to be received with
risk at the same point in time.
Certainty Equivalent Approach
The project is adjusted for risk by
converting the expected risky cash flows
to their certainty equivalents and then
computing the net present value of the
project.
Certainty Equivalent Approach
The risk-free rate, rf not the firms cost
of capital, kis used as the discount
rate for computing the net present value.
This is done because the cost of capital
is a risky rate, reflecting the firms
average risk, and using it would result in
a double counting of risk.
Certainty equivalent factors range from 0
to 1.0. The higher the factor, the more
certain the expected cash flows.
Certainty Equivalent Approach
Algebraically, the certainty equivalent
factor, t, for the cash flows expected to
be received during each time period, t,
are expressed as follows:
t = (Certain return)/(Risky return)
Certainty Equivalent Approach
The certainty equivalent factors are used
to compute a certainty equivalent net
present value as follows:
NCFt tn
NPV -NINV( 0 )
t 1 (1 rf )
t

0 = Certainty equivalent factor associated with the

net investment (NINV) at time 0 (Note: 0 =1)
n = Expected economic life of the project
t = Certainty equivalent factor associated with the
net cash flows (NCF) in each period, t
rf = Risk-free rate
Certainty Equivalent Approach
TABLE 10.1 Calculation of Certainty Equivalent Net Present Value
Year Expected Certainty Certainty PVIF0.08, t Present
NCF Equivalent Equivalent Value of
Factor () Cash Flow Cash Flow
0 $-10,000 1.0 $-10,000 1.000 $-10,000
1 +5,000 0.9 +4,500 0.926 +4,167
2 +6,000 0.8 +4,800 0.857 +4,114
3 +7,000 0.7 +4,900 0.794 +3,891
4 +4,000 0.6 +2,400 0.735 +1,764
5 +3,000 0.4 +1,200 0.681 +817
Certainty Equivalent NPV +$4,753
Certainty Equivalent Approach
The initial outlay of $10,000 is known
with certainty. Hence, the certainty
equivalent factor for year 0 is 1.0, and
the certainty equivalent cash flow is -
$10,000 (= -$10,000*1.0).
Certainty Equivalent Approach
The $5,000 cash inflow in year 1 is
viewed as being somewhat risky.
Consequently, the decision maker has
assigned a certainty equivalent factor
yields a certainty equivalent cash flow of
$4,500. This means that the decision
maker would be indifferent between
receiving the promised, risky $5,000 a
year from now or receiving $4,500 with
certainty at the same time.
Certainty Equivalent Approach
A similar interpretation is given to the
certainty equivalent factors and certainty
equivalent cash flows for years 2
through 5.
Note that the certainty equivalent factors
decline into the future. This reflects the
fact that most cash flows are viewed as
being more risky the further into the
future they are projected to occur.
Certainty Equivalent Approach
In Table 10.1, we have computed the
certainty equivalent net present value for
this project assuming an 8 percent risk-
free rate. It equals $4,753, and the
project therefore is acceptable.
Certainty Equivalent Approach
The certainty equivalent approach of
considering risk is viewed as
conceptually sound for the following
reasons:
The decision maker can adjust separately
each periods cash flows to account for the
specific risk of those cash flows. This
normally is not done when the risk-adjusted
discount rate approach is applied.
Certainty Equivalent Approach
Decision makers must introduce their own
preferences directly into the analysis.
Consequently, the certainty equivalent net
present value provides an unambiguous
basis for making a decision. A positive net
present value means that the project is
acceptable to that decision maker, and a
negative net present value indicates it
should be rejected.
Special Elements of Risk When
Investing Abroad
Captive funds

Foreign government takes over assets

Exchange rate risk

Risk of inflation

Uncertain tax rates