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Chapter 11 -Chapter 11 - Capital BudgetingCapital Budgetingand Risk Analysisand Risk Analysis
2005, Pearson Prentice Hall
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Three Measures of a Project’s Risk Three Measures of a Project’s Risk
Project Standing
Alone Risk
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Three Measures of a Project’s Risk Three Measures of a Project’s Risk
Project Standing
Alone Risk
Risk
diversified away
within firm as this
project is combinedwith firm’s other
projects and assets
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Three Measures of a Project’s Risk Three Measures of a Project’s Risk
Project Standing
Alone Risk
Risk
diversified away
within firm as this
project is combinedwith firm’s other
projects and assets
Project’s
!ontribution"
to"#irm Risk
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Three Measures of a Project’s Risk Three Measures of a Project’s Risk
Project Standing
Alone Risk
Risk
diversified away
within firm as this
project is combinedwith firm’s other
projects and assets
Risk
diversified away
by shareholders as
securities are combined
to form diversified
portfolio
Project’s
!ontribution"
to"#irm Risk
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Three Measures of a Project’s Risk Three Measures of a Project’s Risk
Project Standing
Alone Risk
Risk
diversified away
within firm as this
project is combinedwith firm’s other
projects and assets
Risk
diversified away
by shareholders as
securities are combined
to form diversified
portfolio
Project’s
!ontribution"
to"#irm Risk
Systematic Risk
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$ncorporating Risk into$ncorporating Risk into
!apital %udgeting!apital %udgeting
Two Methods:Two Methods:
!ertainty &'uivalent Approach!ertainty &'uivalent Approach
Risk"Adjusted (iscount RateRisk"Adjusted (iscount Rate
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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 riskyrisk y after"ta3 cash flowsafter"ta3 cash flows
toto certaincertain cash flowscash flows
The idea5The idea5
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!ertainty &'uivalent Approach!ertainty &'uivalent Approach
Adjusts theAdjusts the riskyrisky after"ta3 cash flowsafter"ta3 cash flowstoto certaincertain cash 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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!ertainty &'uivalent Approach!ertainty &'uivalent Approach
Risky !ertainty !ertainRisky !ertainty !ertain
!ash!ash 66 &'uivalent&'uivalent -- !ash !ash
#low #actor /a2 #low#low #actor /a2 #low
Risky 7safe8Risky 7safe8
90::: ;: 9;::90::: ;: 9;::
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!ertainty &'uivalent Approach!ertainty &'uivalent Approach
Risky !ertainty !ertainRisky !ertainty !ertain
!ash!ash 66 &'uivalent&'uivalent -- !ash !ash
#low #actor /a2 #low#low #actor /a2 #low
Risky 7safe8Risky 7safe8
90:::
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TheThe greatergreater the risk associatedthe risk associated
with a particular cash flow4 thewith a particular cash flow4 the
smallersmaller the !& factorthe !& factor
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!ertainty &'uivalent Method!ertainty &'uivalent Method
t+P, - " $.t A!#t/0 1 k rf 2
n
t-0
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!ertainty &'uivalent Approach!ertainty &'uivalent Approach
Steps5Steps5
02 Adjust all after"ta3 cash flows by02 Adjust all after"ta3 cash flows by
certainty e'uivalent factors to getcertainty e'uivalent factors to getcertain cash flowscertain cash flows
>2 (iscount the certain cash flows by>2 (iscount the certain cash flows by
thethe risk"free raterisk"free rate of interestof interest
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$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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Risk"Adjusted (iscount RateRisk"Adjusted (iscount Rate
SimplySimply adjust the discount rate /k2adjust the discount rate /k2 toto
reflect higher riskreflect higher risk
Riskier projects will useRiskier projects will use higherhigher risk"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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Risk"Adjusted (iscount RateRisk"Adjusted (iscount Rate
+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?2 to use*to use* Many firms set upMany firms set up risk classesrisk classes toto
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 Pro ject 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 rate used /risk"used /risk"
adjusted discount rate method24adjusted discount rate method24
Measuring the project’s systematic risk4Measuring the project’s systematic risk4
Analy@ing computer simulation methods4Analy@ing computer simulation methods4
Performing scenario analysis4 andPerforming scenario analysis4 and
Performing sensitivity analysisPerforming sensitivity analysis