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Chapter 11: Capital Budgeting and Risk Analysis 2002, Prentice Hall, Inc.
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Transcript of Chapter 11: Capital Budgeting and Risk Analysis 2002, Prentice Hall, Inc.
![Page 1: Chapter 11: Capital Budgeting and Risk Analysis 2002, Prentice Hall, Inc.](https://reader035.fdocuments.us/reader035/viewer/2022062308/56649d155503460f949ea823/html5/thumbnails/1.jpg)
Chapter 11:Capital Budgeting and
Risk Analysis
2002, Prentice Hall, Inc.
![Page 2: Chapter 11: Capital Budgeting and Risk Analysis 2002, Prentice Hall, Inc.](https://reader035.fdocuments.us/reader035/viewer/2022062308/56649d155503460f949ea823/html5/thumbnails/2.jpg)
Three Measures of a Project’s Risk
Project Standing Alone Risk
![Page 3: Chapter 11: Capital Budgeting and Risk Analysis 2002, Prentice Hall, Inc.](https://reader035.fdocuments.us/reader035/viewer/2022062308/56649d155503460f949ea823/html5/thumbnails/3.jpg)
Three Measures of a Project’s Risk
Project Standing Alone Risk
Risk diversified away
within firm as thisproject is combined
with firm’s otherprojects and assets
![Page 4: Chapter 11: Capital Budgeting and Risk Analysis 2002, Prentice Hall, Inc.](https://reader035.fdocuments.us/reader035/viewer/2022062308/56649d155503460f949ea823/html5/thumbnails/4.jpg)
Three Measures of a Project’s Risk
Project Standing Alone Risk
Risk diversified away
within firm as thisproject is combined
with firm’s otherprojects and assets
Project’scontribution-to-firm risk
![Page 5: Chapter 11: Capital Budgeting and Risk Analysis 2002, Prentice Hall, Inc.](https://reader035.fdocuments.us/reader035/viewer/2022062308/56649d155503460f949ea823/html5/thumbnails/5.jpg)
Three Measures of a Project’s Risk
Project Standing Alone Risk
Risk diversified away
within firm as thisproject is combined
with firm’s otherprojects and assets
Risk diversified away
by shareholders as securities are combined
to form diversifiedportfolio
Project’scontribution-to-firm risk
![Page 6: Chapter 11: Capital Budgeting and Risk Analysis 2002, Prentice Hall, Inc.](https://reader035.fdocuments.us/reader035/viewer/2022062308/56649d155503460f949ea823/html5/thumbnails/6.jpg)
Three Measures of a Project’s Risk
Project Standing Alone Risk
Risk diversified away
within firm as thisproject is combined
with firm’s otherprojects and assets
Risk diversified away
by shareholders as securities are combined
to form diversifiedportfolio
Project’scontribution-to-firm risk
Systematic risk
![Page 7: Chapter 11: Capital Budgeting and Risk Analysis 2002, Prentice Hall, Inc.](https://reader035.fdocuments.us/reader035/viewer/2022062308/56649d155503460f949ea823/html5/thumbnails/7.jpg)
Incorporating Risk into Capital Budgeting
Two Methods:
• Certainty Equivalent Approach
• Risk-Adjusted Discount Rate
![Page 8: Chapter 11: Capital Budgeting and Risk Analysis 2002, Prentice Hall, Inc.](https://reader035.fdocuments.us/reader035/viewer/2022062308/56649d155503460f949ea823/html5/thumbnails/8.jpg)
How can we adjust this model to take risk into account?
NPV = - IO ACFt
(1 + k) t
n
t=1
![Page 9: Chapter 11: Capital Budgeting and Risk Analysis 2002, Prentice Hall, Inc.](https://reader035.fdocuments.us/reader035/viewer/2022062308/56649d155503460f949ea823/html5/thumbnails/9.jpg)
How can we adjust this model to take risk into account?
• Adjust the After-tax Cash Flows (ACFs), or
• Adjust the discount rate (k).
NPV = - IO ACFt
(1 + k) t
n
t=1
![Page 10: Chapter 11: Capital Budgeting and Risk Analysis 2002, Prentice Hall, Inc.](https://reader035.fdocuments.us/reader035/viewer/2022062308/56649d155503460f949ea823/html5/thumbnails/10.jpg)
Certainty Equivalent Approach
• Adjusts the risky after-tax cash flows to certain cash flows.
• The idea:
![Page 11: Chapter 11: Capital Budgeting and Risk Analysis 2002, Prentice Hall, Inc.](https://reader035.fdocuments.us/reader035/viewer/2022062308/56649d155503460f949ea823/html5/thumbnails/11.jpg)
Certainty Equivalent Approach
• Adjusts the risky after-tax cash flows to certain cash flows.
• The idea:
Risky Certainty Certain
Cash X Equivalent = Cash
Flow Factor (a) Flow
![Page 12: Chapter 11: Capital Budgeting and Risk Analysis 2002, Prentice Hall, Inc.](https://reader035.fdocuments.us/reader035/viewer/2022062308/56649d155503460f949ea823/html5/thumbnails/12.jpg)
Certainty Equivalent Approach
Risky Certainty Certain
Cash X Equivalent = Cash
Flow Factor (a) Flow
Risky “safe”
$1000 .70 $700
![Page 13: Chapter 11: Capital Budgeting and Risk Analysis 2002, Prentice Hall, Inc.](https://reader035.fdocuments.us/reader035/viewer/2022062308/56649d155503460f949ea823/html5/thumbnails/13.jpg)
Certainty Equivalent Approach
Risky Certainty Certain
Cash X Equivalent = Cash
Flow Factor (a) Flow
Risky “safe”
$1000 .95 $950
![Page 14: Chapter 11: Capital Budgeting and Risk Analysis 2002, Prentice Hall, Inc.](https://reader035.fdocuments.us/reader035/viewer/2022062308/56649d155503460f949ea823/html5/thumbnails/14.jpg)
• The greater the risk associated with a particular cash flow, the smaller the CE factor.
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Certainty Equivalent Method
tNPV = - IO t ACFt
(1 + krf)
n
t=1
![Page 16: Chapter 11: Capital Budgeting and Risk Analysis 2002, Prentice Hall, Inc.](https://reader035.fdocuments.us/reader035/viewer/2022062308/56649d155503460f949ea823/html5/thumbnails/16.jpg)
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.
![Page 17: Chapter 11: Capital Budgeting and Risk Analysis 2002, Prentice Hall, Inc.](https://reader035.fdocuments.us/reader035/viewer/2022062308/56649d155503460f949ea823/html5/thumbnails/17.jpg)
Incorporating Risk into Capital Budgeting
• Risk-Adjusted Discount Rate
![Page 18: Chapter 11: Capital Budgeting and Risk Analysis 2002, Prentice Hall, Inc.](https://reader035.fdocuments.us/reader035/viewer/2022062308/56649d155503460f949ea823/html5/thumbnails/18.jpg)
How can we adjust this model to take risk into account?
NPV = - IO NPV = - IO ACFACFtt
(1 + k)(1 + k) tt
nn
t=1t=1
![Page 19: Chapter 11: Capital Budgeting and Risk Analysis 2002, Prentice Hall, Inc.](https://reader035.fdocuments.us/reader035/viewer/2022062308/56649d155503460f949ea823/html5/thumbnails/19.jpg)
How can we adjust this model to take risk into account?
• Adjust the discount rate (k).
NPV = - IO NPV = - IO ACFACFtt
(1 + k)(1 + k) tt
nn
t=1t=1
![Page 20: Chapter 11: Capital Budgeting and Risk Analysis 2002, Prentice Hall, Inc.](https://reader035.fdocuments.us/reader035/viewer/2022062308/56649d155503460f949ea823/html5/thumbnails/20.jpg)
Risk-Adjusted Discount Rate
• Simply adjust the discount rate (k) to reflect higher risk.
• Riskier projects will use higher risk-adjusted discount rates.
• Calculate NPV using the new risk-adjusted discount rate.
![Page 21: Chapter 11: Capital Budgeting and Risk Analysis 2002, Prentice Hall, Inc.](https://reader035.fdocuments.us/reader035/viewer/2022062308/56649d155503460f949ea823/html5/thumbnails/21.jpg)
Risk-Adjusted Discount Rate
NPV = - IO ACFt
(1 + k*)t
n
t=1
![Page 22: Chapter 11: Capital Budgeting and Risk Analysis 2002, Prentice Hall, Inc.](https://reader035.fdocuments.us/reader035/viewer/2022062308/56649d155503460f949ea823/html5/thumbnails/22.jpg)
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.
![Page 23: Chapter 11: Capital Budgeting and Risk Analysis 2002, Prentice Hall, Inc.](https://reader035.fdocuments.us/reader035/viewer/2022062308/56649d155503460f949ea823/html5/thumbnails/23.jpg)
Risk Classes
Risk RADR
Class (k*) Project Type
1 12% Replace equipment,
Expand current business
2 14% Related new products
3 16% Unrelated new products
4 24% Research & Development
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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 (risk-adjusted discount rate method),
• Measuring the project’s systematic risk,
• Computer simulation methods,
• Scenario analysis,
• Sensitivity analysis.