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CH 11

CH 11. Capital Budgeting and Risk Analysis. Project Standing Alone Risk. Risk diversified away within firm as this project is combined with firm’s other projects and assets. Project’s Contribution- to-Firm Risk. Risk diversified away by shareholders as securities are combined

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CH 11

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  1. CH 11 Capital Budgeting and Risk Analysis

  2. Project Standing Alone Risk Risk diversified away within firm as this project is combined with firm’s other projects and assets. Project’s Contribution- to-Firm Risk Risk diversified away by shareholders as securities are combined to form diversified portfolio. Systematic Risk Three Measures of a Project’s Risk

  3. Certainty Equivalent Approach Adjust free cash flows (FCF) Use risk-free rate to discount CFs Risk-Adjusted Discount Rate Adjust discounting rate Incorporating Risk into Capital Budgeting Two Approaches

  4. Certainty Equivalent Approach • Adjusts the risky after-tax cash flows to certain cash flows. • The idea: Risky Certainty Certain Cash XEquivalent = Cash Flow Factor (a) Flow

  5. Certainty Equivalent Approach Risky Certainty Certain Cash X Equivalent = Cash Flow Factor (a) Flow Risky “safe” $1000 .70 $700 Risky “safe” $1000 .95 $950

  6. The greater the risk associated with a particular cash flow, the smaller the CE factor.

  7. n t=1 t FCFt (1 + krf) NPV = - IO Certainty Equivalent Method S t

  8. 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.

  9. Incorporating Risk into Capital Budgeting Risk-Adjusted Discount Rate Approach

  10. 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.

  11. n t=1 S FCFt (1 + k*) NPV = - IO t Risk-Adjusted Discount Rate

  12. 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.

  13. 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

  14. RAA approach implies that risk becomes greater as cash flows are further away. Reducing alpha indicates that risk is greater. (Alpha = 1 = Sure thing!

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