Capital Budgeting and Risk Analysis

1. Capital Budgeting and Risk Analysis • Types of risk in capital budgeting • Project stand alone risk – does not differentiate between systematic (non-diversifiable) and unsystematic (diversifiable) risk • Project’s contribution to the firm risk – diversification only at the firm level (project’s contribution to the firm’s risk), but not at the shareholder level is considered • Systematic risk – project’s risk from a well diversified shareholder’s perspective • Focus should be on the systematic risk, however, evidence suggest otherwise. WHY?

2. Types of Risks (Continued) • Project’s contribution to the firm risk together with project’s systematic risk is evaluated because: • Underdiversified shareholders • Bankruptcy costs • Difficulty in measuring a project’s systematic risk

3. Methods for Incorporating Risk into Capital Budgeting • Certainty Equivalent Approach • Uncertain cash flows are replaced by equivalent riskless cash flows based on a decision maker’s preferences and then discounted using the risk-free rate to get NPV • A particular certainty equivalent coefficient tis given by: • Certainty equivalents are likely to reflect managers’ perception which leads to concern over the contribution to firm risk

4. Methods for Incorporating Risk into Capital Budgeting (Continued) • Risk-Adjusted Discount Rate • Simply adjust the discount rate (k) to reflect higher risk (k*) • Riskier projects will use higher risk-adjusted discount rates • Calculate NPV using the new risk-adjusted discount rate • 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

5. Methods for Incorporating Risk into Capital Budgeting (Continued) • Risk-Adjusted Discount Rate 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

6. Methods for Incorporating Risk into Capital Budgeting (Continued) • Risk-Adjusted Discount Rate • How can we estimate the beta of the new project • Use accounting data to estimate Beta – poor beta estimates • Pure play approach – find a publicly traded firm that has the same business as the new project and calculate its beta. Do not forget to make an adjustment for leverage

7. Other Approaches to Evaluating Risk in Capital Budgeting (Continued) • Simulation • Key variables and their distribution characteristics are included in a procedure that is repeated many times • Each time project NPV and/or IRR are calculated • The result gives an idea about potential distribution of NPV and/or IRR • Scenario Analysis – a simulation analysis where three potential cases are analyzed: best, worst and expected • Sensitivity Analysis – one variable is changed while keeping the others constant and effect on NPV and/or IRR is observed

8. Other Approaches to Evaluating Risk in Capital Budgeting (Continued) • Decision Trees • It is best with projects that are executed in different stages • The method incorporates possibilities in every stage

9. Other Approaches to Evaluating Risk in Capital Budgeting (Continued)