Slide 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?

Slide 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

Slide 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  t is given by: Certainty equivalents are likely to reflect managers’ perception which leads to concern over the contribution to firm risk

Slide 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

Slide 5 Methods for Incorporating Risk into Capital Budgeting (Continued) Risk-Adjusted Discount Rate RiskRADR Class(k*)Project Type 112%Replace equipment, Expand current business 214%Related new products 316%Unrelated new products 424%Research & Development

Slide 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

Slide 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

Slide 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

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