capital budgeting and risk analysis
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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 PresentationTRANSCRIPT
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?
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
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
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(
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
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
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
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
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