8-1 Risk Analysis in Investment Decisions CHAPTER 8 McGraw-Hill/Irwin Copyright © 2007 The McGraw-Hill Companies, Inc. All rights reserved.

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8-1 Risk Analysis in Investment Decisions CHAPTER 8 McGraw-Hill/Irwin Copyright © 2007 The McGraw-Hill Companies, Inc. All rights reserved.

8-2 FIGURE 8-1 The Risk-Return Trade-Off Expected return Interest rate on government bonds Investment risk Market line B A  

8-3 FIGURE 8-2 Illustration of Investment Risk: Investment A Has a Lower Expected Return and a Lower Risk Than B

8-4 TABLE 8-1 Diversification Reduces Risk

Number of stocks in portfolio Portfolio risk Standard deviation (%) Unsystematic risk Systematic risk FIGURE 8.3 The Power of Diversification in Common Stock Portfolios

8-6 Source: Meir Statman, “How Many Stocks Make a Diversified Portfolio?” Journal of Financial and Quantitative Analysis 22 (September 1987), pp FIGURE 8.3 (Continued)

8-7 An Example of Sensitivity Analysis

8-8 TABLE 8-2 Book and Market Values of Debt and Equity for Harley-Davidson, Inc.’s (December 31, 2004)

8-9 FIGURE 8.4 Harley-Davidson's Beta Is the Slope of the Best-Fit Line Below

8-10 TABLE 8-3 Representative Company Betas

8-11 TABLE 8-4 Calculation of Harley-Davidson’s Cost of Capital

8-12 Risk-adjusted discount rate or expected return Investment risk Market line Increasing risk- adjusted discount rate Firm’s cost of capital Risk of firm’s existing assets Increasing investment risk FIGURE 8-5 An Investment’s Risk-Adjusted Discount Rate Increases with Risk

… …∞ $14 million per year $100 millionIRR = 14/100 = 14% Cash Flow Diagrams for ABC Industries’ Investment The Enterprise Perspective Cash Flow Diagrams for ABC Industries’ Investment The Enterprise Perspective

… …∞ $12 million per year $60 millionIRR = 12/60 = 20% Cash Flow Diagrams for ABC Industries’ Investment The Equity Perspective Cash Flow Diagrams for ABC Industries’ Investment The Equity Perspective

8-15 TABLE 8-5 When Evaluating Investments under Inflation, Always Compare Nominal Cash Flows to a Nominal Discount Rate or Real Cash Flows to a Real Discount Rate ($ millions)

8-16 TABLE 8-6 General Design’s Diamond Film Project ($ millions) TABLE 8-6 General Design’s Diamond Film Project ($ millions)

8-17 TABLE 8-6 (Continued)

8-18 TABLE 8-7 Use of a Constant Risk-Adjusted Discount Rate Implies That Risk Increases with the Remoteness of a Cash Flow (risk-free rate = 5%; risk-adjusted discount rate =10%)

8-19 TABLE 8-8 Discounting an Investment’s Annual EVA Stream Is Equivalent to Calculating the Investment’s NPV

8-20 TABLE 8-8 (Continued)

8-21 TABLE 8A-1 Estimate of Industry Asset Beta for Harley-Davidson, Inc.

8-22 TABLE 8A-2 Adjusted Present Value Analysis of Automated Irrigation Controller ($ in millions)