Capital Budgeting and Risk

7-1

Risk Adjustment
Techniques

7-2

Two opportunities to adjust the present

value of cash inflows for risk
The

cash inflows can be adjusted

The

discount rate can be adjusted

Cash inflow adjustment process

using certainty Equivalent

7-3

Most direct
approach

and

theoretically

preferred

Represent the percent of estimated cash

inflow that investor would be satisfied to
receive for certain

certainty equivalent method adjusts the

estimated value of the uncertain cash flows.

Cash inflow adjustment process using

certainty Equivalent

The certainty equivalent method uses the rationale that given a risky
cash flow, the decision maker will evaluate this cash flow according to
an expected utility, the utility estimate being hypothesized to be equal
to utility derived from some certain cash flow amount. The decision
maker performs this process for each cash flow. The valuation model is
as follows:
N

V
t 1

7-4

Ct
(1 i )t

where
Ct = certainty equivalent cash flow at period t,

i = riskless interest rate.

Cash inflow adjustment process

using certainty Equivalent

Ct can be expressed as a fraction of the expected value of the cash

flow as follows:

Ct t X t

where tsome fractional value.

The valuation formula becomes

N

V
t 1

(1 i )t

The certainty equivalent method (CE) adjusts for risk directly through
the expected value of the cash flow in each period and then discounts
these risk adjusted cash flows by the risk free rate of interest, Rf. The
formula for this method is given as follows:
N

t X t

t 1

(1 Rf )

NPV

7-5

t X t

I0

Risk Adjusted Discount Rates

More practical approach for risk adjustment (RADRs)

The risk adjusted discount rate method (RADR) is similar to the

NPV. It is defined as the present value of the expected or mean
value of future cash flow distributions discounted at a discount
rate, k, which includes a risk premium for the riskiness of the
cashflows from the project. It is defined by the following
equation:

Xt
NPV
I0
t
t 1 (1 k )
N

7-6

RADR is the rate of return that must be earned on a given

project to compensate the firms owners adequately, thereby
resulting in maintenance or improvement in share price

Logic underlying the use of RADR is closely linked to CAPM

CE VS. RADR in Practice

7-7

CE theoretically preferred approach for risk adjustment.

They separately adjust for risk and time; they first eliminate
risk from cash flows and then discount the certain cash
flows as risk free rate

The RADR have major theoretical problem; it combine risk

and time adjustment in a single discount rate adjustment.

However due to complexity of developing Ces, RADR are

most often in practice. Two reasons:

Consistent with general disposition of decision maker

towards rate of return

Easily estimated and applied

Annualized NPV Approach

7-8

Useful where the projects have unequal lives and

are mutually exclusive projects.

This approach converts the NPV of unequal-lived

proejcts into equivalent(in NPV terms) annual
amount that can be used to select project.

STEPS

Calculate NPV of each project over its life using Cost of Capital

Divide the NPV of each project having a positive NPV by the

present value interest factor for an annuity at the given cost of
capital and the projects life to get annualized NPV of each project

Rank order and select the best project. The project having highest
ANPV would be the best

Annualized NPV Approach

Example

Step-I

NPV of project X with 3 years life and 10% discount rate

is Rs. 11,248

NPV of project Y with 6 years life and 10% discount rate

is Rs. 18,985

Step-II

7-9

By dividing NPV of each project by present valu interest

factor annuity at K and project life

ANPVx= 11248/PVIFA10%, 3Y = 4523

ANPVy= 18985/PVIFA10%, 6Y = 4359

What is Mean by Riskiness of

Project
Riskiness

of an investment project
means the variability of its cash
flows from those that are expected.

Greater

the variability, The riskier the

project said to be

7-10

Problem of Project Risk

Assumption

of single required
rate of return for selection of
project

Different

Projects have different

Risk
Risk
7-11

Return and Firm Value

Mean & Standard Deviation

Mean
For

Value
Frequency data

Weighted
For

Probability Distribution

Standard
7-12

mean

Deviation

An Illustration of Total
Risk (Discrete Distribution)
ANNUAL CASH FLOWS: YEAR 1
PROPOSAL A
State
Deep Recession
Mild Recession
Normal
Minor Boom
Major Boom
7-13

Probability
.05
.25
.40
.25
.05

Cash Flow
$ -3,000
1,000
5,000
9,000
13,000

Probability Distribution
of Year 1 Cash Flows
Proposal A

Probability

.40
.25

.05
-3,000

1,000

5,000

9,000

Cash Flow ($)

7-14

13,000

An Illustration of Total
Risk (Discrete Distribution)
ANNUAL CASH FLOWS: YEAR 1
PROPOSAL B
State
Deep Recession
Mild Recession
Normal
Minor Boom
Major Boom
7-15

Probability
.05
.25
.40
.25
.05

Cash Flow
$ -1,000
2,000
5,000
8,000
11,000

Probability Distribution
of Year 1 Cash Flows
Proposal B

Probability

.40
.25

.05
-3,000

1,000

5,000

9,000

Cash Flow ($)

7-16

13,000

Expectation and Measurement of

Dispersion - A Cash Flow Example
Expected Value: The weighted average of
possible outcomes, with the weights being the
probabilities of occurrence
Standard Deviation: A statistical Measure
of the variability of a distribution around its mean.
It is the square root of the Variance
Coefficient of Variation: The ratio of the
standard deviation of a distribution to the mean
of that distribution. It is a measure of relative risk
7-17

Expected Value of Year 1

Cash Flows (Proposal A)
CF1
$ -3,000
1,000
5,000
9,000
13,000
7-18

P1
.05
.25
.40
.25
.05
S=1.00

(CF1)(P1)
$ -150
250
2,000
2,250
650
CF1=$5,000

Variance of Year 1
Cash Flows (Proposal A)

7-19

(CF1)(P1)

(CF1 - CF1)2(P1)

$ -150
250
2,000
2,250
650
$5,000

( -3,000 - 5,000)2 (.05)

( 1,000 - 5,000)2 (.25)
( 5,000 - 5,000)2 (.40)
( 9,000 - 5,000)2 (.25)
(13,000 - 5,000)2 (.05)

Variance of Year 1
Cash Flows (Proposal A)

7-20

(CF1)(P1)

(CF1 - CF1)2*(P1)

$ -150
250
2,000
2,250
650
$5,000

3,200,000
4,000,000
0
4,000,000
3,200,000
14,400,000

Summary of Proposal A
The standard deviation = SQRT (14,400,000)
= $3,795
The expected cash flow
= $5,000
Coefficient of Variation (CV) = $3,795 / $5,000
= 0.759
CV is a measure of relative risk and is the ratio of
standard deviation to the mean of the distribution.
7-21

An Illustration of Total
Risk (Discrete Distribution)
ANNUAL CASH FLOWS: YEAR 1
PROPOSAL B
State
Deep Recession
Mild Recession
Normal
Minor Boom
Major Boom
7-22

Probability
.05
.25
.40
.25
.05

Cash Flow
$ -1,000
2,000
5,000
8,000
11,000

Probability Distribution
of Year 1 Cash Flows
Proposal B

Probability

.40
.25

.05
-3,000

1,000

5,000

9,000

Cash Flow ($)

7-23

13,000

Expected Value of Year 1

Cash Flows (Proposal B)
CF1

$ -1,000
2,000
5,000
8,000
11,000
7-24

P1

.05
.25
.40
.25
.05
S=1.00

(CF1)(P1)

-50
500
2,000
2,000
550
CF1=$5,000

Variance of Year 1
Cash Flows (Proposal B)
(CF1)(P1)
$

-50
500
2,000
2,000
550
$5,000

7-25

(CF1 - CF1)2(P1)
( -1,000 - 5,000)2 (.05)
( 2,000 - 5,000)2 (.25)
( 5,000 - 5,000)2 (.40)
( 8,000 - 5,000)2 (.25)
(11,000 - 5,000)2 (.05)

Variance of Year 1
Cash Flows (Proposal B)
(CF1)(P1)
$

-50
500
2,000
2,000
550
$5,000

7-26

(CF1 - CF1)2(P1)
1,800,000
2,250,000
0
2,250,000
1,800,000
8,100,000

Summary of Proposal B
The standard deviation = SQRT (8,100,000)
= $2,846
The expected cash flow = $5,000
Coefficient of Variation (CV) = $2,846 / $5,000
= 0.569
The standard deviation of B < A ($2,846< $3,795), so B
is less risky than A.

The coefficient of variation of B < A (0.569<0.759), so B

has less relative risk than A.
7-27

Projects have risk

that may change
from period to
period.

Projects are more

likely to have
continuous, rather
than discrete
distributions.

Cash Flow ($)

Total Project Risk

1
7-28

Year

Assumption of Independence
Cash

Flow in Period t does not

depend on what happened in period
t-1

There

is no causative relationship
between cash flows from period to
period.

Risk
7-29

Free rate for Discounting

Steps to Follow When Cash

Flows are Independent
Mean

Expected Value of Cash Flows

for period t
Standard Deviation of Possible cash
Flows for Period t
Calculate NPV for Proposal
Calculate Standard Deviation for
Proposal
Standardizing the Dispersion
7-30

An Example
EXPECTED CASH FLOWS: YEAR 1

Prob

7-31

Cash Flow

.10

$ 3,000

.25
.30
.25
.10

4,000
5,000
6,000
7,000

An Example
EXPECTED CASH FLOWS: YEAR 2

Prob

Cash Flow

.10 $ 2,000
.25
3,000
.30
4,000
.25
5,000
.10
6,000
7-32

An Example
EXPECTED CASH FLOWS: YEAR 3

Prob

7-33

Cash Flow

.10

$ 2,000

.25
.30
.25
.10

3,000
4,000
5,000
6,000

Standardizing the Dispersion

7-34

The above information help us to evaluate

the risk of investment

If Prob. Distribution is approx. normal(bell

shaped), we are able to calculate the prob.
Of proposal providing a NPV of less than
or more than an amount.

For example we want to determine the

prob. That NPV will be zero or less than
zero.

Assumption of dependence
Cash

Flow in Period t depend on

what happened in period t-1

There

is causative relationship
between cash flows from period to
period.

Risk

7-35

Free rate for Discounting

Steps to Follow When Cash

Flows are dependent
All

steps are same as they were

for the independent projects
except the step 4 which
estimates the standard deviation
for the whole proposal. Different
formula is used for this purpose

7-36

Moderate Correlation

Where the cash flows of the firm are neither

approximately independent nor perfectly correlated
over time, the classification of the cash flow stream
as one or the other is not appropriate

One method for dealing with the moderate correlation

is with a series of conditional probability
distributions.

7-37

Probability Tree Approach

A graphic or tabular approach for
organizing the possible cash-flow
streams generated by an
investment. The presentation
resembles the branches of a tree.
Each complete branch represents
one possible cash-flow sequence.
7-38

Probability Tree Approach

-$900

7-39

Basket Wonders is
examining a project that will
have an initial cost today of
$900. Uncertainty
surrounding the first year
cash flows creates three
possible cash-flow
scenarios in Year 1.

Probability Tree Approach

-$900

7-40

(.20) $1,200 1

Node 1: 20% chance of a

$1,200 cash-flow.

(.60)

$450

Node 2: 60% chance of a

$450 cash-flow.

(.20)

-$600 3

Node 3: 20% chance of a

-$600 cash-flow.

Year 1

Probability Tree Approach

(.10) $2,200
(.20) $1,200 1

-$900

(.60)

$450

(.60) $1,200
(.30) $ 900
(.35) $ 900
(.40) $ 600

Each node in
Year 2
represents a
branch of our
probability
tree.

(.25) $ 300
(.10) $ 500
(.20)

-$600 3

(.50) -$ 100
(.40) -$ 700

7-41

Year 1

Year 2

The
probabilities
are said to be
conditional
probabilities.

Joint Probabilities [P(1,2)]

(.10) $2,200
(.20) $1,200 1

-$900

(.60)

$450

(.60) $1,200
(.30) $ 900
(.35) $ 900
(.40) $ 600
(.25) $ 300
(.10) $ 500

(.20)

-$600 3

(.50) -$ 100
(.40) -$ 700

7-42

Year 1

Year 2

.02 Branch 1

.12 Branch 2
.06 Branch 3
.21 Branch 4

.24 Branch 5
.15 Branch 6
.02 Branch 7

.10 Branch 8
.08 Branch 9

Project NPV Based on

Probability Tree Usage
z

The probability
tree accounts for
the distribution
of cash flows.
Therefore,
discount all cash
flows at only the
risk-free rate of
return.
7-43

NPV = iS= 1 (NPVi)(Pi)

The NPV for branch i of
the probability tree for two
years of cash flows is

NPVi =

CF1

(1 + Rf
- ICO

)1

CF2
(1 + Rf )2

NPV for Each Cash-Flow

Stream at 5% Risk-Free Rate
(.10) $2,200
(.20) $1,200 1

-$900

(.60)

$450

(.60) $1,200
(.30) $ 900
(.35) $ 900
(.40) $ 600
(.25) $ 300
(.10) $ 500

(.20)

-$600 3

(.50) -$ 100
(.40) -$ 700

7-44

Year 1

Year 2

$ 2,238.32

$ 1,331.29
$ 1,059.18
$

344.90

$
-$

72.79
199.32

-$ 1,017.91

-$ 1,562.13
-$ 2,106.35

Calculating the Expected

Net Present Value (NPV)
Branch
Branch 1
Branch 2
Branch 3
Branch 4
Branch 5
Branch 6
Branch 7
Branch 8
Branch 9

NPVi
$ 2,238.32
$ 1,331.29
$ 1,059.18
$ 344.90
$
72.79
-$ 199.32
-$ 1,017.91
-$ 1,562.13
-$ 2,106.35

P(1,2)
.02
.12
.06
.21
.24
.15
.02
.10
.08

NPVi * P(1,2)
$ 44.77
$159.75
$ 63.55
$ 72.43
$ 17.47
-$ 29.90
-$ 20.36
-$156.21
-$168.51

Expected Net Present Value = -$ 17.01

7-45

Calculating the Variance

of the Net Present Value
NPVi
$ 2,238.32
$ 1,331.29
$ 1,059.18
$ 344.90
$
72.79
-$ 199.32
-$ 1,017.91
-$ 1,562.13
-$ 2,106.35

P(1,2)
.02
.12
.06
.21
.24
.15
.02
.10
.08

(NPVi - NPV )2[P(1,2)]

$ 101,730.27
$ 218,149.55
$ 69,491.09
$ 27,505.56
$ 1,935.37
$ 4,985.54
$ 20,036.02
$ 238,739.58
$ 349,227.33

Variance = $1,031,800.31
7-46

Summary of the
Decision Tree Analysis
The standard deviation =
SQRT ($1,031,800) = $1,015.78
The expected NPV

7-47

= -$

17.01

Determining the Expected

NPV for a Portfolio of Projects
m

NPVP = S ( NPVj )
j=1

NPVP is the expected portfolio NPV,

NPVj is the expected NPV of the jth

NPV that the firm undertakes,
m is the total number of projects in
the firm portfolio.
7-48

Determining Portfolio
Standard Deviation
sP =

S k=1
S sjk

j=1

sjk is the covariance between possible

NPVs for projects j and k,

s jk = s j s k r jk .

sj is the standard deviation of project j,

sk is the standard deviation of project k,
7-49

rjk is the correlation coefficient between

projects j and k.

Managerial (Real) Options

Management flexibility to make
future decisions that affect a
projects expected cash flows, life,
or future acceptance.
Project Worth = NPV +
Option(s) Value
7-50

Managerial (Real) Options

Expand (or contract)
Allows

the firm to expand (contract) production

if conditions become favorable (unfavorable).

Abandon
Allows

the project to be terminated early.

Postpone
Allows

the firm to delay undertaking a project

(reduces uncertainty via new information).

7-51