Chapter 12 Risk and Refinements on CB © 2012 Pearson Prentice Hall. All rights reserved. 10-1

© 2012 Pearson Prentice Hall. All rights reserved Introduction to Risk in Capital Budgeting Thus far, we have assumed that all investment projects have the same level of risk as the firm. In other words, we assumed that all projects are equally risky, and the acceptance of any project would not change the firm ’ s overall risk. In actuality, these situations are rare — projects are not equally risky, and the acceptance of a project can affect the firm ’ s overall risk.

© 2012 Pearson Prentice Hall. All rights reserved Behavioral Approaches for Dealing with Risk: Risk and Cash Inflows Behavioral approaches can be used to get a “ feel ” for the level of project risk, whereas other approaches try to quantify and measure project risk. Risk (in capital budgeting) refers to the uncertainty surrounding the cash flows that a project will generate or, more formally, the degree of variability of cash flows. In many projects, risk stems almost entirely from the cash flows that a project will generate several years in the future, because the initial investment is generally known with relative certainty.

© 2012 Pearson Prentice Hall. All rights reserved Behavioral Approaches for Dealing with Risk: Scenario Analysis Scenario analysis is a behavioral approach that uses several possible alternative outcomes (scenarios), to obtain a sense of the variability of returns, measured here by NPV. In capital budgeting, one of the most common scenario approaches is to estimate the NPVs associated with pessimistic (worst), most likely (expected), and optimistic (best) estimates of cash inflow. The range can be determined by subtracting the pessimistic-outcome NPV from the optimistic-outcome NPV.

© 2012 Pearson Prentice Hall. All rights reserved Table 12.2 Scenario Analysis of Treadwell’s Projects A and B

© 2012 Pearson Prentice Hall. All rights reserved Project Risk

© 2012 Pearson Prentice Hall. All rights reserved Behavioral Approaches for Dealing with Risk: Simulation Simulation is a statistics-based behavioral approach that applies predetermined probability distributions and random numbers to estimate risky outcomes. The Monte Carlo Method: The Forecast Is for Less Uncertainty –To combat uncertainty in the decision-making process, some companies use a Monte Carlo simulation program to model possible outcomes. –A Monte Carlo simulation program randomly generates values for uncertain variables over and over to simulate a model. –One of the problems with using a Monte Carlo program is the difficulty of establishing the correct input ranges for the variables and determining the correlation coefficients for those variables.

© 2012 Pearson Prentice Hall. All rights reserved International Risk Considerations Exchange rate risk is the danger that an unexpected change in the exchange rate between the dollar and the currency in which a project ’ s cash flows are denominated will reduce the market value of that project ’ s cash flow. –In the short term, much of this risk can be hedged –Long-term exchange rate risk can best be minimized by financing the project in whole or in part in the local currency. Political risk is much harder to protect against. –Governments can seize the firm ’ s assets, or otherwise interfere with a project ’ s operation. –They can do so either by adjusting a project ’ s expected cash inflows to account for the probability of political interference or by using risk-adjusted discount rates in capital budgeting formulas.

© 2012 Pearson Prentice Hall. All rights reserved Risk-Adjusted Discount Rates Risk-adjusted discount rates (RADR) are rates of return that must be earned on a given project to compensate the firm ’ s owners adequately — that is, to maintain or improve the firm ’ s share price. The higher the risk of a project, the higher the RADR—and thus the lower a project’s NPV.

© 2012 Pearson Prentice Hall. All rights reserved Risk-Adjusted Discount Rates: Review of CAPM Using beta, b j, to measure the relevant risk of any asset j, the CAPM is r j = R F + [b j  (r m – R F )] where rjrj =required return on asset j RFRF =risk-free rate of return bjbj =beta coefficient for project j rmrm =return on the market portfolio of assets

© 2012 Pearson Prentice Hall. All rights reserved Figure 12.2 CAPM and SML

© 2012 Pearson Prentice Hall. All rights reserved How do we get the RADR Managers can characterize projects by – Risk indexes – Risk classes How this is done varies – Could be subjective – Could be statistical Lets say a CV > 2.7 = risk class 4 or risk index 7

© 2012 Pearson Prentice Hall. All rights reserved Risk-Adjusted Discount Rates: Applying RADRs (cont.)

© 2012 Pearson Prentice Hall. All rights reserved Table 12.3 Bennett Company’s Risk Classes and RADRs

© 2012 Pearson Prentice Hall. All rights reserved Risk-Adjusted Discount Rates: Portfolio Effects As noted earlier, individual investors must hold diversified portfolios because they are not rewarded for assuming diversifiable risk. Because business firms can be viewed as portfolios of assets, it would seem that it is also important that they too hold diversified portfolios. Surprisingly, however, empirical evidence suggests that firm value is not affected by diversification. In other words, diversification is not normally rewarded and therefore is generally not necessary.

© 2012 Pearson Prentice Hall. All rights reserved Capital Budgeting Refinements: Comparing Projects With Unequal Lives But when unequal-lived projects are mutually exclusive, the impact of differing lives must be considered because they do not provide service over comparable time periods. – This is particularly important when continuing service is needed from the projects under consideration.

© 2012 Pearson Prentice Hall. All rights reserved Capital Budgeting Refinements: Comparing Projects With Unequal Lives (cont.) The AT Company, a regional cable-TV firm, is evaluating two projects, X and Y. The projects ’ cash flows and resulting NPVs at a cost of capital of 10% is given below.

© 2012 Pearson Prentice Hall. All rights reserved Annualized NPV (ANPV) Capital Budgeting Refinements: Comparing Projects With Unequal Lives (cont.) CB: Unequal Lives

© 2012 Pearson Prentice Hall. All rights reserved Capital Rationing Firm ’ s often operate under conditions of capital rationing — they have more acceptable independent projects than they can fund. In theory, capital rationing should not exist — firms should accept all projects that have positive NPVs. However, in practice, most firms operate under capital rationing. Generally, firms attempt to isolate and select the best acceptable projects subject to a capital expenditure budget set by management.

© 2012 Pearson Prentice Hall. All rights reserved Capital Rationing The internal rate of return approach is an approach to capital rationing that involves graphing project IRRs in descending order against the total dollar investment to determine the group of acceptable projects. The graph that plots project IRRs in descending order against the total dollar investment is called the investment opportunities schedule (IOS). The problem with this technique is that it does not guarantee the maximum dollar return to the firm.

© 2012 Pearson Prentice Hall. All rights reserved Capital Rationing Tate Company, a fast growing plastics company with a cost of capital of 10%, is confronted with six projects competing for its fixed budget of $250,000.

© 2012 Pearson Prentice Hall. All rights reserved IRR Approach Assume the firm’s cost of capital is 10% and has a maximum of $250,000 available for investment. Ranking the projects according to IRR, the optimal set of projects for Tate is B, C, and E, However project A and F are acceptable project!s! They have an IRR greater than the cost of capital!! CB: Capital Rationing

© 2012 Pearson Prentice Hall. All rights reserved Figure 12.4 Investment Opportunities Schedule

© 2012 Pearson Prentice Hall. All rights reserved Capital Rationing (cont.) The net present value approach is an approach to capital rationing that is based on the use of present values to determine the group of projects that will maximize owners ’ wealth. It is implemented by ranking projects on the basis of IRRs and then evaluating the present value of the benefits from each potential project to determine the combination of projects with the highest overall present value.

© 2012 Pearson Prentice Hall. All rights reserved NPV Approach Now we will rank by NPV. With the $250,000 limit in investment we will only do projects C, B, and A While projects E & F clearly will add wealth to the shareholder. Why? CB: Capital Rationing