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13
Risk and Capital
Budgeting
Chapter
McGraw-Hill/Irwin
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Outline
• Concept of risk based on uncertainties.
• Investors and their averseness to risk.
• Investors expected higher rate of return on
risky projects.
• Simulation models and decision trees.
• Consequences of risky projects both
individually and for the firm as a whole.
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Evaluation and Management of Risk
• Price of a stock is largely influenced by the
amount of risk.
• Ideal situation for a firm is to achieve an
approximate mix between profitability and
risk.
• The challenge lies in determining an
appropriate position on the risk-return scale.
13-3
Definition of Risk in Capital
Budgeting
• Risk is defined in terms of variability of
possible outcomes from a given investment.
• Risk is measured not only in terms of losses
but also in terms of uncertainty.
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Variability and Risk
13-5
The Concept of Risk-Averse
• Based on the assumption that - most
investors and managers are risk averse.
– Preference: relative certainty as opposed to
uncertainty.
– Expectation: higher value or return for risky
investments.
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Actual Measurement of Risk
•
Basic statistical devices used.
– Expected value: D = ∑ DP
– Standard deviation: σ = ∑ (D – D)2 P
– Co-efficient of Variation: (V) = σ
D
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Profitability Distribution with
Differing Degrees of Risk
13-8
Profitability Distribution with
Differing Degrees of Risk (cont’d)
13-9
Betas for Five-Year Period (Ending
January 2006)
13-10
Risk and the Capital Budgeting
Process
• Informed investors and managers need to
decide between:
– Investments that produce ‘certain’ returns.
– Investments that produces an expected value of
return, apart from having a high coefficient of
variation.
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Risk-Adjusted Discount Rate
• Using different discount rates for proposals
with different risk levels.
– Investment with normal amount of risk may be
discounted at the cost of capital.
– Investments carrying greater than normal risk
will be discounted at a higher rate and so on.
• Risk is assumed to be measured by the
coefficient of variation (V).
13-12
Relationship of Risk to Discount
Rate
13-13
Increasing Risk over Time
• Accurate forecasting becomes more obscure
farther out in time.
• Unexpected events:
– Create a higher standard of deviation in cash
flows.
– Increase the risk associated with long-lived
projects.
• Using progressively higher discount rates to
compensate for risk tends to penalize late
flows more than early flows.
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Qualitative Measures
• Setting up of risk classes based on
qualitative considerations.
13-15
Risk Categories and Associated
Discount Rates
13-16
Example: Risk-adjusted Discount
Rate
• Assumption (Table 13-4):
– An investment calls for an addition to the normal
product line and is assigned a discount rate of
10%.
– Another investment represents a new product in
a foreign market and must carry a 20% discount
rate to adjust for a large risk component.
– First investment is the only acceptable
alternative.
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Capital Budgeting Analysis
13-18
Capital Budgeting Decision Adjusted
for Risk
13-19
Simulation Models
• Help in dealing with uncertainties involved in
forecasting the outcome of capital budgeting
projects or other decisions.
– Computers enable the simulation of various
economic and financial outcomes, using a
number of variables.
• A Monte Carlo simulation model uses random
variable for inputs.
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Simulation Models (cont’d)
– Rely on repetition of the same random process
as many as several hundred times.
– Have the ability to test various combinations of
events.
– Are used to test possible changes in variable
conditions included in the process.
– Are driven by sales forecasts, with the
assumption to derive income statements and
balance sheets.
– Generate probability acceptance curves for
capital budgeting decisions.
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Simulation of Flow Chart
13-22
Decision Trees
• Helps in laying out a sequence of decisions
that can be made.
• Presents a tabular or graphical comparison
between investment choices.
• Provides an important analytical process.
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Decision Trees (cont’d)
• Assuming that a firm is considering two choices:
– Expanding the production for sale to end users.
– Entering the highly competitive personal computer
market using the firm’s technology.
• Cost of both projects is $60 million, with different net
present value (NPV) and risk.
• Project A: high likelihood of positive rate of return and
the long-run growth is a reasonable expectation.
• Project B: stiff competition may result in loss of more
money or higher profit if sales are high.
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Decision Trees (cont’d)
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The Portfolio Effect
• Considers the impact of a given investment
on the overall risk of the firm.
– A firm may plan to invest in the building products
industry carrying a high degree of risk.
• The overall risk exposure of that firm might diminish.
• The investing firm could alter cyclical fluctuations
inherent in its business and reduce overall risk
exposure.
• Thus, standard deviation for the entire company has
been reduced.
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Portfolio Risk
• Changes in overall risk of a firm depends on
its relationship with other investments.
– Highly correlated investments - do not really
diversify away risk.
– Negatively correlated investments provide a
high degree of risk reduction.
– Uncorrelated investments provide some overall
reduction in portfolio risk.
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Coefficient of Correlation
• Represents extent of correlation among
projects.
– A measure that may take on values anywhere
from -1 to +1.
• More likely measure case is a measure between -.2
negative correlation and +.3 positive correlation.
• Risk can be reduced by:
– Combining risky assets with low or negatively
correlated assets.
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Rates of Return for Conglomerate,
Inc., and Two Merger Candidates
13-29
Evaluation of Combinations
• Choosing between the variable points or
combinations – should meet two primary
objectives:
– Achieve the highest possible return at a given
risk level.
– Provide the lowest possible risk at a given return
level.
• After developing the best risk-return line efficient frontier:
– Determine the position of the firm on that line.
13-30
Risk-Return Trade-Off
13-31
The Share Price Effect
• When a firm takes unnecessary or
undesirable risk:
– Higher discount rate and a lower valuation may
have to assigned to the stock in the market.
• Higher profits, resulting from risky ventures,
could however, have an opposite result.
– The overall valuation of a firm might decrease
with an increase in coefficient of variation, or
beta.
13-32