Chapter 11 - Capital Budgeting

and Risk Analysis

2005, Pearson Prentice Hall

Three Measures of a Projects Risk

Project Standing
Alone Risk

Three Measures of a Projects Risk

Project Standing
Alone Risk
Risk
diversified away
within firm as this
project is combined
with firms other
projects and assets.

Three Measures of a Projects Risk

Project Standing
Alone Risk

Projects
Contributionto-Firm Risk

Risk
diversified away
within firm as this
project is combined
with firms other
projects and assets

Three Measures of a Projects Risk

Project Standing
Alone Risk

Projects
Contributionto-Firm Risk

Risk
diversified away
within firm as this
project is combined
with firms other
projects and assets.

Risk
diversified away
by shareholders as
securities are combined
to form diversified
portfolio.

Three Measures of a Projects Risk

Project Standing
Alone Risk

Projects
Contributionto-Firm Risk

Systematic Risk

Risk
diversified away
within firm as this
project is combined
with firms other
projects and assets.

Risk
diversified away
by shareholders as
securities are combined
to form diversified
portfolio.

Incorporating Risk into

Capital Budgeting
Two Methods:
Certainty Equivalent Approach
Risk-Adjusted Discount Rate

How can we adjust this model to

take risk into account?
n

NPV =

t=1

FCFt
t
(1 + k)

- IO

How can we adjust this model to

take risk into account?
n

NPV =

t=1

FCFt
t
(1 + k)

- IO

Adjust the After-tax Cash Flows (ACFs),

or
Adjust the discount rate (k).

Certainty Equivalent Approach

Adjusts the risky after-tax cash flows
to certain cash flows.
The idea:

Certainty Equivalent Approach

Adjusts the risky after-tax cash flows
to certain cash flows.
The idea:
Risky
Cash
Flow

Certainty
Equivalent
Factor (a)

Certain
=
Cash
Flow

Certainty Equivalent Approach

Risky
Cash X
Flow
Risky
$1000

Certainty
Equivalent
Factor (a)

.70

Certain
Cash
Flow
safe
$700

Certainty Equivalent Approach

Risky
Cash X
Flow
Risky
$1000

Certainty
Equivalent
Factor (a)

.95

Certain
Cash
Flow
safe
$950

 The greater the risk associated

with a particular cash flow, the
smaller the CE factor.

Certainty Equivalent Method

n

NPV =

t=1

ACFt
IO
t
(1 + krf)
t

Certainty Equivalent Approach

Steps:
1) Adjust all after-tax cash flows by
certainty equivalent factors to get
certain cash flows.
2) Discount the certain cash flows by
the risk-free rate of interest.

Incorporating Risk into

Capital Budgeting

Risk-Adjusted Discount Rate

How can we adjust this model

to take risk into account?
n

NPV =

t=1

ACFt
t
(1 + k)

- IO

How can we adjust this model

to take risk into account?
n

NPV =

t=1

ACFt
t
(1 + k)

- IO

Adjust the discount rate (k).

Risk-Adjusted Discount Rate

Simply adjust the discount rate (k) to
reflect higher risk.
Riskier projects will use higher riskadjusted discount rates.
Calculate NPV using the new riskadjusted discount rate.

Risk-Adjusted Discount Rate

n

NPV =

t=1

FCFt
- IO
t
(1 + k*)

Risk-Adjusted Discount Rates

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.

Risk Classes
Risk RADR
Class (k*)
1
12%
2
3
4

14%
16%
24%

Project Type
Replace equipment,
Expand current business
Related new products
Unrelated new products
Research & Development

Summary: Risk and

Capital Budgeting
You can adjust your capital budgeting
methods for projects having different levels
of risk by:
Adjusting the discount rate used (riskadjusted discount rate method),
Measuring the projects systematic risk,
Analyzing computer simulation methods,
Performing scenario analysis, and
Performing sensitivity analysis.