Principles of Managerial Finance

9th Edition

Chapter 10
Risk & Refinements in Capital Budgeting

Learning Objectives
Understand the importance of explicitly recognizing risk in the analysis of capital budgeting projects. Discuss breakeven cash flow, sensitivity and scenario analysis, and simulation as behavioral approaches for dealing with risk, and the unique risks facing multinational companies. Describe the two basic risk-adjustment techniques in terms of NPV and the procedures for applying the certainty equivalent (CE) approach.

Learning Objectives
Review the use of risk-adjusted discount rates (RADRs), portfolio effects, and the practical aspects of RADRs relative to CEs. Recognize the problem caused by unequal-lived mutually exclusive projects and the use of annualized net present values (ANPVs) to resolve it. Explain the objective of capital rationing and the two basic approaches to project selection under it.

Behavioral Approaches for Dealing with Risk

In the context of the capital budgeting projects discussed in this chapter, risk results almost entirely from the uncertainty about future cash inflows because the initial cash outflow is generally known. These risks result from a variety of factors including uncertainty about future revenues, expenditures and taxes. Therefore, to asses the risk of a potential project, the analyst needs to evaluate the riskiness of the cash inflows.

Behavioral Approaches for Dealing with Risk

Sensitivity Analysis
Treadwell Tire has a 10% cost of capital and is considering investing in one of two mutually exclusive projects A or B. Each project has a $10,000 initial cost and a useful life of 15 years. As financial manager, you have provided pessimistic, most-likely, and optimistic estimates of the equal annual cash inflows for each project as shown in the following table.

Behavioral Approaches for Dealing with Risk

Sensitivity Analysis

Behavioral Approaches for Dealing with Risk

Simulation
Simulation is a statistically-based behavioral approach that applies predetermined probability distributions and random numbers to estimate risky outcomes. Figure 10.1 presents a flowchart of the simulation of the NPV of a project. The use of computers has made the use of simulation economically feasible, and the resulting output provides an excellent basis for decision-making.

Behavioral Approaches for Dealing with Risk

Simulation

Behavioral Approaches for Dealing with Risk

International Risk Consideration
Exchange rate risk is the risk that an unexpected change in the exchange rate will reduce NPV of a projects cash flows. In the short term, much of this risk can be hedged by using financial instruments such as foreign currency futures and options. Long-term exchange rate risk can best be minimized by financing the project in whole or in part in the local currency.

Behavioral Approaches for Dealing with Risk

International Risk Considerations
Political risk is much harder to protect against once a project is implemented. A foreign government can block repatriation of profits and even seize the firms assets. Accounting for these risks can be accomplished by adjusting the rate used to discount cash flows -- or better -- by adjusting the projects cash flows.

Behavioral Approaches for Dealing with Risk

International Risk Considerations
Since a great deal of cross-border trade among MNCs takes place between subsidiaries, it is also important to determine the net incremental impact of a projects cash flows overall. As a result, it is important to approach international capital projects from a strategic viewpoint rather than from a strictly financial perspective.
<0 NPV project

Risk-Adjustment Techniques
Certainty Equivalents
Bennett Company is currently evaluating two projects, A and B. The firms cost of capital is 10% and the initial investment and operating cash flows are shown on the following slide.

Risk-Adjustment Techniques
Certainty Equivalents
Bennett Company
Project's A and B (10% cost of Captial) Year 0 1 2 3 4 5 NPV Project A $ 14,000 14,000 14,000 14,000 14,000 $11,071 Project B (45,000) 28,000 12,000 10,000 10,000 10,000 $10,924 (42,000) $

Risk-Adjustment Techniques
Certainty Equivalents
Assume that it is determined that Project A is actually more risky than B. To adjust for this risk, you decide to apply certainty equivalents (CEs) to the cash flows, where CEs represent the percentage of the cash flows that you would be satisfied to receive for certain rather than the original (possible) cash flows.

Risk-Adjustment Techniques
Certainty Equivalents
Bennett Com any
Certainty Equivalents Applied to Project A (Risk-free rate = 6%) Cer Year $ 2 3 4 5 r ect A 42 4 4 4 4 4 9 9 8 7 6 CE Cash flow s $ $ $ $ $ $ 42 26 26 2 98 84 9434 89 8396 792 7473 $ PVIF resent Value $ 42 887 2 4 94 4 7 763 6 277 4 544

Net Present Value

Risk-Adjustment Techniques
Certainty Equivalents
Bennett Com any
Certainty Equivalents (Risk-free rate Cert in ear Project B ( ) CE Cash flow s ( ) PVI lied to Project B ) resent Val e ( )

project A

Net Present Val e

Risk-Adjustment Techniques
Risk-Adjusted Discount Rates
Bennett Company also wishes to apply the RiskAdjusted Discount Rate (RADR) approach to determine whether to implement Project A or B. To do so, Bennett has developed the following Risk Index to assist them in their endeavor.

Risk-Adjustment Techniques
Risk-Adjusted Discount Rates
R qu R k I 0.0 0.2 0.4 0.6 0.8 1.0 1.2 1.4 1.6 1.8 2.0 x R tu (R DR) 6% 7% 8% 9% 10% 11% 12% 13% 14% 15% 16%

Risk-Adjustment Techniques
Risk-Adjusted Discount Rates
Project B has been assigned a Risk Index Value of 1.0 (average risk) with a RADR of 11%, and Project A has been assigned a Risk Index Value of 1.6 (above average risk) with a RADR of 14%. These rates are then applied as the discount rates to the two projects to determine NPV as shown on the following slide.

Risk-Adjustment Techniques
Risk-Adjusted Discount Rates
Bennett Company
Risk st iscount Rat (RADR = 14%) P esent ear 1 2 3 4 5 Project A (42,000) 14,000 14,000 14,000 14,000 14,000 PVIF 1.0000 .8772 .7695 .6750 .5921 .5194 $ Value (42,000) 12,281 10,773 9,450 8,289 7,271 6,063 ied to P oject A

Net Present Value

Risk-Adjustment Techniques
Risk-Adjusted Discount Rates
CAPM project RADR

Bennett Company
Risk Adjusted Discount Rate Applied to Project B (RADR = 11%) Present Year Project B PVIF Value

E(ri ) ! rf  Fi [E(rm )  rf ]
IRR

SML
IRR

rf

project IRR SML accept the project NPV>0 project IRR SML reject the project NPV<0

Net Present Value

Risk-Adjustment Techniques
Portfolio Effects
As noted in Chapter , 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.

Risk-Adjustment Techniques
Portfolio Effects
It turns out that firms are not rewarded for diversification because investors can do so themselves. An investor can diversify more readily, easily, and costlessly simply by holding portfolios of stocks.

Risk-Adjustment Techniques
CE Versus RADR in Practice
In general, CEs are the theoretically preferred approach for project risk adjustment because they separately adjust for risk and time. CEs first eliminate risk from the cash flows and then discount the certain cash flows at a risk-free rate. RADRs on the other hand, have a major theoretical problem: they combine the risk and time adjustments in a single discount rate adjustment.

Risk-Adjustment Techniques
CE Versus RADR in Practice
Because of the mathematics of discounting, the RADR approach implicitly assumes that risk is an increasing function of time. However, because of the complexity in developing CEs, RADRs are more often used in practice. More specifically, firms often establish a number of risk classes, with an RADR assigned to each. Projects are then placed in the appropriate risk class and the corresponding RADR is then applied.

Capital Budgeting Refinements

Comparing Projects With Unequal Lives
If projects are independent, comparing projects with unequal lives is not critical. 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
The AT mpany a regi nal cable-TV firm is evalua ing w pr jec s X and . The pr jec s cash fl ws and resul ing PVs a a c s f capi al f 10% is given bel w.
Pr jec X ear 0 1 as 0 000 000 000 000 Pr jec l ws 000 000 0 000 000 0 000 1 000 10 000 PV $11 277 $19 013

Capital Budgeting Refinements

Comparing Projects With Unequal Lives
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. Ignoring the difference in their useful lives, both projects are acceptable (have positive NPVs). Furthermore, if the projects were mutually exclusive, project Y would be preferred over project X. However, it is important to recognize that at the end of its 3 year life, project Y must be replaced, or renewed. Although a number of approaches are available for dealing with unequal lives, we will present the most efficient technique -- the annualized NPV approach.

Capital Budgeting Refinements

Comparing Projects With Unequal Lives
Annualized NPV (ANPV) The ANPV approach converts the NPV of unequal-lived projects into an equivalent (in NPV terms) annual amount that can be used to select the best project. 1. Calculate the NPV of each project over its live using the appropriate cost of capital. 2. Divide the NPV of each positive NPV project by the PVIFA at the given cost of capital and the projects live to get the ANPV for each project. 3. Select the project with the highest ANPV.

Capital Budgeting Refinements

Comparing Projects With Unequal Lives
Annualized NPV (ANPV) 1. Calculate the NPV for projects X and Y at 10%. NPVX = $11,277; NPVY = $19,013. 2. Calculate the ANPV for Projects X and Y. ANPVX = $11,277/PVIFA10%,3 years = $4,534 ANPVY = $19,013/PVIFA10%,6 years = $4,366 3. Choose the project with the higher ANPV. Pick project X.

Capital Rationing
Firms 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, research has found that management internally imposes capital expenditure constraints to avoid what it deems to be excessive levels of new financing, particularly debt. Thus, the objective of capital rationing is to select the group of projects within the firms budget that provides the highest overall NPV

Capital Rationing
Example
Gould Com any Investment Proposals k=10%
Project A B C D E F ta vestm e t 0 000 0 000 100 000 0 000 0 000 110 000 RR 1 % 0% 1 % % 1 % 11% 1 PV of Inf ow s 100 000 11 000 1 000 000 000 00 1 NPV 0 000 000 000 000 1 000 00

Capital Rationing
IRR Approach G
(R Pr ject B C E
capital constraint 0,000 B C E

l Pr
k b IRR IRR 20% 16% 15% 12% 11%

ls
I itial I v $ t e t

70,000 100,000 60,000 80,000 110,000 40,000

8%

Capital Rationing
IRR Approach
Assume the firm c st f capital i 10% an has a maximum f $250,000 available f r investment. Ranking the pr jects acc r ing t IRR, the ptimal et f pr jects f r G ul i B, , an E.
G ul Pr
I i ial Pr ject B C E IRR I estm ent , , , , , D ,

al
u ulati e , , , , , ,

um ulative Investm ent) Investm ent

Capital Rationing
IRR Approach
If w e ra tio n c a p ita l u s in g the IR R a p p ro a c h a n d m a in ta in the ra n k in gs p ro v id e d b y IR R , the to ta l P V o f in flo w s a n d N P V w o u ld b e $336,000 a n d $106,000 re s p e c tiv e ly.

Gould Company Investment Proposals

(Ranked by IRR) PV of Project B C E Totals IRR Inflows Initial Investment NPV

Capital Rationing
NPV Approach
C B A

Ho w ever, if w e ran k them su ch that N P V is m axim ized , then w e can u se o u r en tire b u d get an d raise the P V o f in flo w s an d N P V to $357,000 an d $107,000 resp ectively.

B C E 0,000

NPV

10 ,000

Gould Company Investment Proposals

(Ranked by NPV) PV of Project B C A Totals
B C E A F IRR k=10

Initial Investment NPV

( ) (1) ( )

IRR

Inflow s