Chapter McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Risk and Capital Budgeting 13

13-2 Chapter Outline Concept of risk based on uncertainties. Investors and their averseness to risk. Investors expected higher rate of return on risky projects. Simulation models and decision trees. Consequences of risky projects both individually and for the firm as a whole.

13-3 Evaluation and Management of Risk Price of a stock is largely influenced by the amount of risk. Ideal situation for a firm is to achieve an approximate mix between profitability and risk. The challenge lies in determining an appropriate position on the risk-return scale.

13-4 Definition of Risk in Capital Budgeting Risk is defined in terms of variability of possible outcomes from a given investment. Risk is measured not only in terms of losses but also in terms of uncertainty.

13-5 Variability and Risk

13-6 The Concept of Risk-Averse Based on the assumption that - most investors and managers are risk averse. –Preference: relative certainty as opposed to uncertainty. –Expectation: higher value or return for risky investments.

13-7 Actual Measurement of Risk Basic statistical devices used. –Expected value: D = ∑ DP –Standard deviation: σ = ∑ (D – D) 2 P –Co-efficient of Variation: (V) = σ D

13-8 Profitability Distribution with Differing Degrees of Risk

13-9 Profitability Distribution with Differing Degrees of Risk (cont’d)

13-10 Betas for Five-Year Period (Ending January 2006)

13-11 Risk and the Capital Budgeting Process Informed investors and managers need to decide between: –Investments that produce ‘certain’ returns. –Investments that produces an expected value of return, apart from having a high coefficient of variation.

13-12 Risk-Adjusted Discount Rate Using different discount rates for proposals with different risk levels. –Investment with normal amount of risk may be discounted at the cost of capital. –Investments carrying greater than normal risk will be discounted at a higher rate and so on. Risk is assumed to be measured by the coefficient of variation (V).

13-13 Relationship of Risk to Discount Rate

13-14 Increasing Risk over Time Accurate forecasting becomes more obscure farther out in time. Unexpected events: –Create a higher standard of deviation in cash flows. –Increase the risk associated with long-lived projects. Using progressively higher discount rates to compensate for risk tends to penalize late flows more than early flows.

13-15 Qualitative Measures Setting up of risk classes based on qualitative considerations.

13-16 Risk Categories and Associated Discount Rates

13-17 Example: Risk-adjusted Discount Rate Assumption (Table 13-4): –An investment calls for an addition to the normal product line and is assigned a discount rate of 10%. –Another investment represents a new product in a foreign market and must carry a 20% discount rate to adjust for a large risk component. –First investment is the only acceptable alternative.

13-18 Capital Budgeting Analysis

13-19 Capital Budgeting Decision Adjusted for Risk

13-20 Simulation Models Help in dealing with uncertainties involved in forecasting the outcome of capital budgeting projects or other decisions. –Computers enable the simulation of various economic and financial outcomes, using a number of variables. A Monte Carlo simulation model uses random variable for inputs.

13-21 Simulation Models (cont’d) –Rely on repetition of the same random process as many as several hundred times. –Have the ability to test various combinations of events. –Are used to test possible changes in variable conditions included in the process. –Are driven by sales forecasts, with the assumption to derive income statements and balance sheets. –Generate probability acceptance curves for capital budgeting decisions.

13-22 Simulation of Flow Chart

13-23 Decision Trees Helps in laying out a sequence of decisions that can be made. Presents a tabular or graphical comparison between investment choices. Provides an important analytical process.

13-24 Decision Trees (cont’d) Assuming that a firm is considering two choices: –Expanding the production for sale to end users. –Entering the highly competitive personal computer market using the firm’s technology. Cost of both projects is $60 million, with different net present value (NPV) and risk. Project A: high likelihood of positive rate of return and the long-run growth is a reasonable expectation. Project B: stiff competition may result in loss of more money or higher profit if sales are high.

13-25 Decision Trees (cont’d)

13-26 The Portfolio Effect Considers the impact of a given investment on the overall risk of the firm. –A firm may plan to invest in the building products industry carrying a high degree of risk. The overall risk exposure of that firm might diminish. The investing firm could alter cyclical fluctuations inherent in its business and reduce overall risk exposure. Thus, standard deviation for the entire company has been reduced.

13-27 Portfolio Risk Changes in overall risk of a firm depends on its relationship with other investments. –Highly correlated investments - do not really diversify away risk. –Negatively correlated investments provide a high degree of risk reduction. –Uncorrelated investments provide some overall reduction in portfolio risk.

13-28 Coefficient of Correlation Represents extent of correlation among projects. –A measure that may take on values anywhere from -1 to +1. More likely measure case is a measure between -.2 negative correlation and +.3 positive correlation. Risk can be reduced by: –Combining risky assets with low or negatively correlated assets.

13-29 Rates of Return for Conglomerate, Inc., and Two Merger Candidates

13-30 Evaluation of Combinations Choosing between the variable points or combinations – should meet two primary objectives: –Achieve the highest possible return at a given risk level. –Provide the lowest possible risk at a given return level. After developing the best risk-return line - efficient frontier: –Determine the position of the firm on that line.

13-31 Risk-Return Trade-Off

13-32 The Share Price Effect When a firm takes unnecessary or undesirable risk: –Higher discount rate and a lower valuation may have to assigned to the stock in the market. Higher profits, resulting from risky ventures, could however, have an opposite result. –The overall valuation of a firm might decrease with an increase in coefficient of variation, or beta.