capital budgeting and risk analysis

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Slide 1 Capital Budgeting and Risk Analysis Types of risk in capital budgeting Project stand alone risk – does not differentiate between systematic (non- diversifiable) and unsystematic (diversifiable) risk Project’s contribution to the firm risk – diversification only at the firm level (project’s contribution to the firm’s risk), but not at the shareholder level is considered Systematic risk – project’s risk from a well diversified shareholder’s perspective Focus should be on the systematic risk, however, evidence suggest otherwise. WHY?

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Capital Budgeting and Risk Analysis. Types of risk in capital budgeting Project stand alone risk – does not differentiate between systematic (non-diversifiable) and unsystematic (diversifiable) risk - PowerPoint PPT Presentation

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Page 1: Capital Budgeting and Risk Analysis

Slide 1

Capital Budgeting and Risk Analysis

Types of risk in capital budgeting Project stand alone risk – does not differentiate between

systematic (non-diversifiable) and unsystematic (diversifiable) risk

Project’s contribution to the firm risk – diversification only at the firm level (project’s contribution to the firm’s risk), but not at the shareholder level is considered

Systematic risk – project’s risk from a well diversified shareholder’s perspective

Focus should be on the systematic risk, however, evidence suggest otherwise. WHY?

Page 2: Capital Budgeting and Risk Analysis

Slide 2

Types of Risks (Continued)

Project’s contribution to the firm risk together with project’s systematic risk is evaluated because: Underdiversified shareholders Bankruptcy costs Difficulty in measuring a project’s systematic risk

Page 3: Capital Budgeting and Risk Analysis

Slide 3

Methods for Incorporating Risk into Capital Budgeting

Certainty Equivalent Approach Uncertain cash flows are replaced by equivalent riskless cash

flows based on a decision maker’s preferences and then discounted using the risk-free rate to get NPV

A particular certainty equivalent coefficient t is given by:

Certainty equivalents are likely to reflect managers’ perception which leads to concern over the contribution to firm risk

IO)k1(

FCFNPV

flow cash expected orrisky flow cash certain

n

1it

rf

tt

t

tt

Page 4: Capital Budgeting and Risk Analysis

Slide 4

Methods for Incorporating Risk into Capital Budgeting (Continued)

Risk-Adjusted Discount Rate Simply adjust the discount rate (k) to reflect higher risk (k*) Riskier projects will use higher risk-adjusted discount rates Calculate NPV using the new risk-adjusted discount rate

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

IOk

FCFNPVn

it

t

1 *)1(

Page 5: Capital Budgeting and Risk Analysis

Slide 5

Methods for Incorporating Risk into Capital Budgeting (Continued)

Risk-Adjusted Discount RateRisk RADR Class (k*) Project Type 1 12% Replace equipment, Expand current business 2 14% Related new products 3 16% Unrelated new products 4 24% Research & Development

Page 6: Capital Budgeting and Risk Analysis

Slide 6

Methods for Incorporating Risk into Capital Budgeting (Continued)

Risk-Adjusted Discount Rate How can we estimate the beta of the new project Use accounting data to estimate Beta – poor beta estimates Pure play approach – find a publicly traded firm that has the

same business as the new project and calculate its beta. Do not forget to make an adjustment for leverage

Page 7: Capital Budgeting and Risk Analysis

Slide 7

Other Approaches to Evaluating Risk in Capital Budgeting (Continued)

Simulation Key variables and their distribution characteristics are included

in a procedure that is repeated many times Each time project NPV and/or IRR are calculated The result gives an idea about potential distribution of NPV

and/or IRR Scenario Analysis – a simulation analysis where three

potential cases are analyzed: best, worst and expected Sensitivity Analysis – one variable is changed while

keeping the others constant and effect on NPV and/or IRR is observed

Page 8: Capital Budgeting and Risk Analysis

Slide 8

Other Approaches to Evaluating Risk in Capital Budgeting (Continued)

Decision Trees It is best with projects that are executed in different stages The method incorporates possibilities in every stage

Year 0 JointIO Cash Flow Probability Cash Flow Probability Probability

(1,000,000) 600,000 0.50 300,000 0.20 0.10600,000 0.80 0.40

1.00700,000 0.30 300,000 0.20 0.06

500,000 0.30 0.09700,000 0.50 0.15

1.00800,000 0.20 400,000 0.80 0.16

600,000 0.10 0.02800,000 0.10 0.02

1.00 1.00 1.00

Year 1 Year 2

Page 9: Capital Budgeting and Risk Analysis

Slide 9

Other Approaches to Evaluating Risk in Capital Budgeting (Continued)

15.00%

JointPath Probability Year 0 Year 1 Year 2 NPV IRR

1 0.10 (1,000,000) 600,000 300,000 ($251,418) -7.55%2 0.40 (1,000,000) 600,000 600,000 ($24,575) 13.07%3 0.06 (1,000,000) 700,000 300,000 ($164,461) 0.00%4 0.09 (1,000,000) 700,000 500,000 ($13,233) 13.90%5 0.15 (1,000,000) 700,000 700,000 $137,996 25.69%6 0.16 (1,000,000) 800,000 400,000 ($1,890) 14.83%7 0.02 (1,000,000) 800,000 600,000 $149,338 27.18%8 0.02 (1,000,000) 800,000 800,000 $300,567 37.98%

1.00 ($16,635) 13.25%

Required ReturnPotential Cash Flow Streams