Capital Budgeting and Risk Pertemuan Matakuliah: A0774/Information Technology Capital Budgeting Tahun: 2009

Risk Risk is to be distinguished from uncertainty –Uncertainty refers to a situation wherein the decision maker is not able to predict the possible outcome of his proposed decision. –Probability distribution of outcomes is unknowns. In normal terms, the risk associated with a project may be defined as the variability that is likely to occur in the future returns from the project. –The greater the variability of future returns of a project, the riskier the project.

Types of project risks (1)Stand alone risk which views the risk of a project in isolation (2) Corporate risk which views the risk of a project within the context of firm’s combination of project.

Risk of Different Types of Projects A riskier project should promise a higher return to prompt its acceptance The decision maker aims at identifying different types of risk to which projects are subject to, so that differential risk allowances may be determined which would reduce all such projects to a common basis. The compilation of differential risk allowances is a subjective judgment.

Risk of Different Types of Projects (A)Cost Saving Investments –Those which apply to established operations –Those which apply to planned operation For an investment relating to established operation, operation will continue regardless of investment as there will be a continuous demand for the product or services of the proposed investment. This reduces the risks associated with such an investment.

Risk of Different Types of Projects (B) Replacement Investments –Replacement investment are often akin to cost saving investments in that where they form part of larger continuing projects –They do not add to the firm’s main risks. –Therefore, replacement will be justified whenever the projected return exceeds the firm’s cost of capital by quite a small margin

Risk of Different Types of Projects (C) Expansion Investment –Project designed to expand a firm’s markets are often the riskiest projects. –Such investment involve intensive and costly advertising, development and test marketing. –The loss can be substantial if the product fails to gain significant share of the market.

Risk of Different Types of Projects (D) Investments Required by Regulations –Most firms will be required to undertake some investments because these are required by government regulations and enactments. The provision of effluent treatment plant, dust control equipment, fire fighting equipment, etc., fall into these categories.

Risk of Different Types of Projects (E) Amenity Investments –Firms generally undertake welfare amenity investments of some kind. These may range from the provision of canteens and rest rooms to sport and social clubs. –These investments are aimed at boosting employee morale and commitment.

Measurement of Risk Probability distributions –A probability distribution is defined as a set of possible outcomes, with a probability of occurrence attached to each outcome. The standard deviation –A measure of a project’s riskiness is particularly clear is particularly clear if we assume that the probability distribution involved is of the type described as normal.

Measurement of Risk (A)Project Variance (Independence of Cash Flows) With independence of cash flows over time, there is no causative relationship between cash flows from period to period. (B)Project Variance (Dependence of Cash Flows) The variance of a project whose net cash flows are interdependent is made up of two components: (i)The sum of variances of net cash flows for each period (ii)Co-variance’s representing interrelationship between net cash flows of different periods.

Approaches to Risk Adjustment (a)Expected Net Present Value (ENPV) The concept of expected NPV may be used for project appraisal in an uncertain world because world because it provides an average value of the proposed project’s performance. (b) Payback Method Payback method represents a traditional way of assessing investment projects under risk conditions.

Approaches to Risk Adjustment (c) Adjustments in the Discount Rate to use a risk-adjusted discount rate for investment appraisal, the company simply adds to the current risk free rate an additional premium, the of which is arbitrarily determined by the estimated riskiness of the project being evaluated. (d) Use of Normal Distribution the approach starts from the premise that if a project’s risk can be defined as the degree of possible variability between its expected outcome and its actual outcome, then what would be of interest to the decision maker is the probability of the project actually producing a positive net present value

Approaches to Risk Adjustment (e) Sensitivity Analysis it is a widely used approach to the problem of uncertainty. It is concerned with judging the sensitivity of items of data which are needed to make a decision.

Approaches to Risk Adjustment A capital investment simulation model generally considers the following variables in deriving an investment’s earnings stream : 1. Market size 2. Selling price 3. Market growth rate 4. Share of market 5. Investment required 6. Residual value of investment 7. Operating costs 8. Fixed costs 9. Economic life of investment