FM10e_ch11_1 - trim Capital Budgeting and Risk Analysis.ppt

8/9/2019 FM10e_ch11_1 - trim Capital Budgeting and Risk Analysis.ppt

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Chapter 11 -Chapter 11 - Capital BudgetingCapital Budgetingand Risk Analysisand Risk Analysis


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Three Measures of a Projects RiskThree Measures of a Projects Risk

Project Standing

Alone Risk


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Project Standing

Alone Risk

Risk

diversified away

within firm as this

project is combinedwith firms other

projects and assets


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Project Standing

Alone Risk

Risk

diversified away

within firm as this


projects and assets

Projects

!ontribution"

to"#irm Risk


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Project Standing

Alone Risk

Risk

diversified away

within firm as this


projects and assets

Risk

diversified away

by shareholders as

securities are combined

to form diversified

portfolio

Projects

!ontribution"

to"#irm Risk


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Project Standing

Alone Risk

Risk

diversified away

within firm as this


projects and assets

Risk

diversified away

by shareholders as

securities are combined

to form diversified

portfolio

Projects

!ontribution"

to"#irm Risk

Systematic Risk


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)ow can we adjust this model to)ow can we adjust this model to

take risk into account*take risk into account*

+P, - " $.#!#t

/0 1 k2 t

n

t-0


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)ow can we adjust this model to)ow can we adjust this model to

take risk into account*take risk into account*

Adjust the After"ta3 !ash #lows /A!#s24Adjust the After"ta3 !ash #lows /A!#s24

oror

Adjust the discount rate /k2Adjust the discount rate /k2

+P, - " $.#!#t

/0 1 k2 t

n

t-0


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!ertainty &'uivalent Approach!ertainty &'uivalent Approach

Adjusts theAdjusts the riskyriskyafter"ta3 cash flowsafter"ta3 cash flows

toto certaincertaincash flowscash flows

The idea5The idea5


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Adjusts theAdjusts the riskyriskyafter"ta3 cash flowsafter"ta3 cash flowstoto certaincertaincash flowscash flows

The idea5The idea5

Risky !ertainty !ertainRisky !ertainty !ertain

!ash!ash 66 &'uivalent&'uivalent -- !ash !ash

#low #actor /a2 #low#low #actor /a2 #low


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Risky 7safe8Risky 7safe8

90::: ;: 9;::90::: ;: 9;::


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Risky 7safe8Risky 7safe8

90:::


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TheThe greatergreaterthe risk associatedthe risk associated

with a particular cash flow4 thewith a particular cash flow4 the

smallersmallerthe !& factorthe !& factor


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!ertainty &'uivalent Method!ertainty &'uivalent Method

t+P, - " $.tA!#t/0 1 krf2

n

t-0


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Steps5Steps5

02 Adjust all after"ta3 cash flows by02 Adjust all after"ta3 cash flows by

certainty e'uivalent factors to getcertainty e'uivalent factors to getcertain cash flowscertain cash flows

>2 (iscount the certain cash flows by>2 (iscount the certain cash flows by

thethe risk"free raterisk"free rateof interestof interest


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$ncorporating Risk into$ncorporating Risk into

!apital %udgeting!apital %udgeting

Risk"Adjusted (iscount RateRisk"Adjusted (iscount Rate


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)ow can we adjust this model)ow can we adjust this model

to take risk into account*to take risk into account*

+P, - " $.+P, - " $.A!#A!#tt

/0 1 k2/0 1 k2 tt

nn

t-0t-0


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)ow can we adjust this model)ow can we adjust this model

to take risk into account*to take risk into account*

Adjust the discount rate /k2Adjust the discount rate /k2

+P, - " $.+P, - " $.A!#A!#tt

/0 1 k2/0 1 k2 tt

nn

t-0t-0


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SimplySimply adjust the discount rate /k2adjust the discount rate /k2toto

reflect higher riskreflect higher risk

Riskier projects will useRiskier projects will use higherhigherrisk"risk"adjusted discount ratesadjusted discount rates

!alculate +P, using the new risk"!alculate +P, using the new risk"

adjusted discount rateadjusted discount rate


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+P, - " $.#!#t

/0 1 k?2t

n

t-0


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Risk"Adjusted (iscount RatesRisk"Adjusted (iscount Rates

)ow do we determine the)ow do we determine the

appropriate risk"adjusted discountappropriate risk"adjusted discount

raterate /k?2/k?2to use*to use* Many firms set upMany firms set up risk classesrisk classestoto

categori@e different types of projectscategori@e different types of projects


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Risk !lassesRisk !lasses

Risk RA(RRisk RA(R

!lass!lass /k?2/k?2 Project Type Project Type

0 0> Replace e'uipment40 0> Replace e'uipment4

&3pand current business&3pand current business

> 0B Related new products> 0B Related new products

C 0D Enrelated new productsC 0D Enrelated new products

B >B Research F (evelopmentB >B Research F (evelopment


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Summary5Summary5 Risk andRisk and

!apital %udgeting!apital %udgeting

Gou can adjust your capital budgetingGou can adjust your capital budgeting

methods for projects having different levelsmethods for projects having different levels

of risk by5of risk by5

Adjusting theAdjusting the discount ratediscount rateused /risk"used /risk"

adjusted discount rate method24adjusted discount rate method24

Measuring the projects systematic risk4Measuring the projects systematic risk4

Analy@ing computer simulation methods4Analy@ing computer simulation methods4

Performing scenario analysis4 andPerforming scenario analysis4 and

Performing sensitivity analysisPerforming sensitivity analysis

FM10e_ch11_1 - trim Capital Budgeting and Risk Analysis.ppt

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