13 Chapter Risk and Capital Budgeting McGraw-Hill Ryerson ©2003 McGraw-Hill Ryerson Limited

DETERMINATION OF APPROPRIATE DISCOUNT RATE CAPITAL BUDGETING PROJECTS Chapter Objective DETERMINATION OF APPROPRIATE DISCOUNT RATE FOR CAPITAL BUDGETING PROJECTS

PPT 13-3 What is Risk? Investment proposals are judged on the basis of return and risk Risk means uncertainty about a future outcome Investments are risky because future cash flows will likely vary from forecasts Risk varies greatly, depending on the investment: A T-Bill has zero or no risk Nortel at $120 had high risk Most investors and managers don’t like risk The maximum risk acceptable depends on the investor’s aversion to risk The higher the risk, the higher the required return

Methods of Dealing With Risk PPT 13-4 Methods of Dealing With Risk Compute the Expected Value and Standard Deviation Compare the risk of the investment to the company’s Beta Increase the discount rate for riskier projects Certainty equivalents - adjust cash flows estimates for risk

Statistical Measurement of Risk PPT 13-6 Statistical Measurement of Risk Expected Value: equals the weighted average of possible outcomes (forecasts) times their probabilities Gives you the most likely forecast / your best estimate Standard Deviation: measure of dispersion or variability around the expected value gives you a measure of the spread of possible outcomes larger the standard deviation  greater the risk

Beta Beta is a statistical measure of volatility PPT 13-13 Beta Beta is a statistical measure of volatility It measures how responsive or sensitive a company’s stock is to market movements in general An individual stock’s beta shows how it compares to the market as a whole: beta = 1 means equal risk with the market beta > 1 means more risky than the market beta < 1 means less risky than the market Company risk may provide guideline to risk of a new investment in that company

Table 13-2 Betas, 2002 PPT 13-14 Company Name Beta Air Canada . . . . . . . . . . . . . 1.81 Alcan Aluminum. . . . . . . . . . . . . . . 1.28 BCE Inc. . . . . . . . . . . . . . . . . . . . 1.30 Inco . . . . . . . . . . . . . . . . . . . . . 1.32 Nortel . . . . . . . . . . . . . . . . . . . . . 2.21 Royal Bank . . . . . . . . . . . . . . . . . . 0.82 Source:www.nasdaq-canada.com www.thomsoninvest.net www.stern.nyu.edu/~adamodar/New Home Page/datafile/Betas.html

Figure 13-5 Relationship of risk to discount rate PPT 13-15 Figure 13-5 Relationship of risk to discount rate Discount rate (per cent) 20 15 10 6 .30 .60 .90 1.20 Risk (β) 10% cost of capital + 5% risk premium Cost of capital Risk-free rate Extreme risk Normal risk Discount rate

Table 13-3 Risk categories and associated discount rates PPT 13-16 Table 13-3 Risk categories and associated discount rates Discount Rate Low or no risk (repair to old machinery) . . . . . . . . . 6% Moderate risk (new equipment) . . . . . . . . . . . . . . . . . 8 Normal risk (addition to normal product line) . . . . . 10 Risky (new product in related market). . . . . . . . . . . . 12 High risk (completely new market) . . . . . . . . . . . . . . 16 Highest risk (new product in foreign market) . . . . . . 20

Table 13-4 Capital budgeting analysis PPT 13-17 Table 13-4 Capital budgeting analysis Investment A Investment B Year (10% discount rate) Year (10% discount rate) P.V. P.V. 1 $5,000 $4,545 1 $1,500 $1,364 2 5,000 4,132 2 2,000 1,653 3 2,000 1,502 3 2,500 1,878 $10,180 4 5,000 3,415 5 5,000 3,105 $11,415 Present value of inflows $ 10,180 Present value of inflows $11,415 Investment 10,000 Investment 10,000 Net present value $ 180 Net present value $ 1,415

Table 13-5 Capital budgeting decision adjusted for risk PPT 13-18 Table 13-5 Capital budgeting decision adjusted for risk Investment A Investment B Year (10% discount rate) Year (20% discount rate) 1 $5,000 $4,545 1 $1,500 $1,250 2 5,000 4,130 2 2,000 1,389 3 2,000 1,503 3 2,500 1,447 $10,180 4 5,000 2,411 5 5,000 2,009 $ 8,506 Present value of inflows $10,180 Present value of inflows $ 8,506 Investment 10,000 Investment 10,000 Net present value $ 180 Net present value $ (1,494)

Summary and Conclusions PPT 13-26 Summary and Conclusions Risk is considered as the variability of the potential outcomes from an investment Managers tend to be risk-adverse Methods of incorporating risk in capital budgeting include: standard deviation and Beta The portfolio effect considers the effect of a new investment on the overall risk of the firm