Chapter 12 Risk and Refinements on CB

Chapter 12 Risk and

Refinements on CB

© 2012 Pearson Prentice Hall. All rights reserved. 10-1


Introduction to Risk in Capital

Budgeting

• Thus far, we have assumed that all investment projects

have the same level of risk as the firm.

• In other words, we assumed that all projects are equally

risky, and the acceptance of any project would not change

the firm’s overall risk.

• In actuality, these situations are rare—projects are not

equally risky, and the acceptance of a project can affect

the firm’s overall risk.


Behavioral Approaches for Dealing

with Risk: Risk and Cash Inflows

• Behavioral approaches can be used to get a “feel” for the level of project risk, whereas other approaches try to quantify and measure project risk.

• Risk (in capital budgeting) refers to the uncertainty surrounding the cash flows that a project will generate or, more formally, the degree of variability of cash flows.

• In many projects, risk stems almost entirely from the cash flows that a project will generate several years in the future, because the initial investment is generally known with relative certainty.


Behavioral Approaches for Dealing

with Risk: Scenario Analysis

• Scenario analysis is a behavioral approach that uses several possible alternative outcomes (scenarios), to obtain a sense of the variability of returns, measured here by NPV.

• In capital budgeting, one of the most common scenario approaches is to estimate the NPVs associated with pessimistic (worst), most likely (expected), and optimistic (best) estimates of cash inflow.

• The range can be determined by subtracting the pessimistic-outcome NPV from the optimistic-outcome NPV.


Table 12.2 Scenario Analysis of

Treadwell’s Projects A and B


Project Risk


Behavioral Approaches for

Dealing with Risk: Simulation

Simulation is a statistics-based behavioral approach that

applies predetermined probability distributions and random

numbers to estimate risky outcomes.

The Monte Carlo Method: The Forecast Is for Less Uncertainty

– To combat uncertainty in the decision-making process, some companies use a Monte Carlo simulation program to model possible outcomes.

– A Monte Carlo simulation program randomly generates values for uncertain variables over and over to simulate a model.

– One of the problems with using a Monte Carlo program is the difficulty of establishing the correct input ranges for the variables and determining the correlation coefficients for those variables.


International Risk

Considerations

• Exchange rate risk is the danger that an unexpected change in the exchange rate between the dollar and the currency in which a project’s cash flows are denominated will reduce the market value of that project’s cash flow.

– In the short term, much of this risk can be hedged

– Long-term exchange rate risk can best be minimized by financing the project in whole or in part in the local currency.

• Political risk is much harder to protect against.

– Governments can seize the firm’s assets, or otherwise interfere with a

project’s operation.

– They can do so either by adjusting a project’s expected cash inflows to

account for the probability of political interference or by using risk-adjusted

discount rates in capital budgeting formulas.


Risk-Adjusted Discount Rates

Risk-adjusted discount rates (RADR) are rates of return

that must be earned on a given project to compensate the

firm’s owners adequately—that is, to maintain or improve

the firm’s share price.

The higher the risk of a project, the higher the RADR—and

thus the lower a project’s NPV.


Risk-Adjusted Discount Rates:

Review of CAPM

Using beta, bj, to measure the relevant risk of any asset j, the

CAPM is

rj = RF + [bj (rm – RF)]

where

rj = required return on asset j

RF = risk-free rate of return

bj = beta coefficient for project j

rm = return on the market portfolio of assets


Figure 12.2

CAPM and SML


How do we get the RADR

• Managers can characterize projects by

– Risk indexes

– Risk classes

• How this is done varies

– Could be subjective

– Could be statistical

• Lets say a CV > 2.7 = risk class 4 or risk index 7



Applying RADRs (cont.)


Table 12.3 Bennett Company’s

Risk Classes and RADRs



Portfolio Effects

• As noted earlier, individual investors must hold diversified portfolios because they are not rewarded for assuming diversifiable risk.

• Because business firms can be viewed as portfolios of assets, it would seem that it is also important that they too hold diversified portfolios.

• Surprisingly, however, empirical evidence suggests that firm value is not affected by diversification.

• In other words, diversification is not normally rewarded and therefore is generally not necessary.


Capital Budgeting Refinements:

Comparing Projects With Unequal Lives

• But when unequal-lived projects are mutually

exclusive, the impact of differing lives must be

considered because they do not provide service

over comparable time periods.

– This is particularly important when continuing service is

needed from the projects under consideration.


Capital Budgeting Refinements: Comparing

Projects With Unequal Lives (cont.)

The AT Company, a regional cable-TV firm, is evaluating

two projects, X and Y. The projects’ cash flows and

resulting NPVs at a cost of capital of 10% is given below.

Project X Project Y

Year

0 (70,000)$ (85,000)$

1 28,000$ 35,000$

2 33,000$ 30,000$

3 38,000$ 25,000$

4 -$ 20,000$

5 -$ 15,000$

6 -$ 10,000$

NPV $11,277 $19,013

Cash Flows


Annualized NPV (ANPV)

Capital Budgeting Refinements: Comparing

Projects With Unequal Lives (cont.)

CB: Unequal Lives


Capital Rationing

• Firm’s often operate under conditions of capital rationing—they have more acceptable independent projects than they can fund.

• In theory, capital rationing should not exist—firms should accept all projects that have positive NPVs.

• However, in practice, most firms operate under capital rationing.

• Generally, firms attempt to isolate and select the best acceptable projects subject to a capital expenditure budget set by management.

http://www.youtube.com/watch?feature=player_detailpage&v=qOjLLRFsp1I

http://www.youtube.com/watch?feature=player_detailpage&v=qOjLLRFsp1I


Capital Rationing (cont.)

• The internal rate of return approach is an approach to capital rationing that involves graphing project IRRs in descending order against the total dollar investment to determine the group of acceptable projects.

• The graph that plots project IRRs in descending order against the total dollar investment is called the investment opportunities schedule (IOS).

• The problem with this technique is that it does not guarantee the maximum dollar return to the firm.



Tate Company, a fast growing plastics company with a cost

of capital of 10%, is confronted with six projects competing

for its fixed budget of $250,000.

Project Initial Investment IRR PV of Inflows NPV

A 80,000$ 12% 100,000$ 20,000$

B 70,000 20% 112,000 42,000

C 100,000 16% 145,000 45,000

D 40,000 8% 36,000 (4,000)

E 60,000 15% 79,000 19,000

F 110,000 11% 126,500 16,500


IRR Approach Assume the firm’s

cost of capital

is 10% and has

a maximum of

$250,000 available

for investment.

Ranking the

projects according

to IRR, the

optimal set of

projects for

Tate is B, C,

and E,

However project A and F are

acceptable project!s! They have an

IRR greater than the cost of capital!!

CB: Capital Rationing


Figure 12.4 Investment

Opportunities Schedule



• The net present value approach is an approach to capital

rationing that is based on the use of present values to

determine the group of projects that will maximize

owners’ wealth.

• It is implemented by ranking projects on the basis of IRRs

and then evaluating the present value of the benefits from

each potential project to determine the combination of

projects with the highest overall present value.


NPV Approach Now we will rank by NPV.

With the $250,000 limit in

investment we will only do

projects C, B, and A

While projects E & F clearly

will add wealth to the

shareholder.

Why?

CB: Capital Rationing

Cost of Capital and Investing


Part 1

http://www.youtube.com/watch?feature=player_detailp

age&v=PDA1F6e5mW4

Part 2


age&v=X4uPRQTKqTA

Part 3


age&v=aH5S8e19Cn4

Part 4


age&v=aH5S8e19Cn4

http://www.youtube.com/watch?feature=player_detailpage&v=PDA1F6e5mW4

http://www.youtube.com/watch?feature=player_detailpage&v=PDA1F6e5mW4

http://www.youtube.com/watch?feature=player_detailpage&v=X4uPRQTKqTA

http://www.youtube.com/watch?feature=player_detailpage&v=X4uPRQTKqTA

http://www.youtube.com/watch?feature=player_detailpage&v=aH5S8e19Cn4




Documents

Chapter 12 Risk and Refinements on CB