RISK AND

REFINEMENT IN
CAPITAL BUDGETING

INTRODUCTION OF RISK TO
CAPITAL BUDGETING
Risk

is the uncertainty about a

projects future profitability.

The
Risk

degree of variability of cash flows.

results almost entirely from the

uncertainty about future cash inflows.
The initial outflow is generally known.

INTRODUCTION OF RISK TO
CAPITAL BUDGETING
Factors

future
taxes.
Project

include uncertainty about

revenues, expenditures and

cash flows typically have

different levels of risk and the
acceptance of a project does affect
the firms overall risk.

BEHAVORIAL APPROACHES FOR

DEALING WITH RISK

Sensitivity
Scenario

Analysis

Analysis

Simulations

SENSITIVITY ANALYSIS

Measures
Sensitivity of NPV
to change in key
variables of the
cash flow
estimates

STEPS IN CONDUCTING
SENSITIVITY ANALYSIS
Identify

key variables
Specify base case based on
Expected Values
Specify a Percent Change around
the expected value or specify
worst and best values for a key
variable. Calculate NPV
Repeat for all key variables

r = 10% ;
n = 10 years

IMPLICATIONS ON THE GIVEN

EXAMPLE
Expresses

cash flows in terms of key

variables and calculates the consequences
of misestimating values.

Project
Very

is not sure to have positive NPV

sensitive to market share and unit price

may be worthwhile to seek further information

about these variables (e.g. more research, pilot
Unit

NPV

variable cost and fix cost have positive

DRAWBACKS OF SENSITIVITY
ANALYSIS
Treats

every variable in isolation

Ignores

the inter relationship of

variables

Does

NPV

not provide a likely range of

SCENARIO ANALYSIS
Scenario

analysis is a behavioral
approach similar to sensitivity
analysis but is broader in scope.

Measures

the sensitivity to changes

in more than one or all key variables.
For example market share, unit
price, cash outflows etc.

NPV

is then calculated under each

different set of variable assumptions.

STEPS IN CONDUCTING
SCENARIO ANALYSIS
Identify

key variables

Specify

values of the variables

given cases of specific events and
economic conditions.

Calculate

NPV across Values in

each scenario

SCENARIO ANALYSIS
Does

not specify how likely is the

occurrence of any given scenario.

Specifies
Shows

a range for NPV.

how a project would fare

under different economic
condition

SIMULATION MODELS
Statistics-based

behavioral approach
that applies predetermined
probability distributions and random
numbers to estimate risky outcomes.
Computer aided simulations can
consider infinite number of
combinations.
Complex computer aided models
also model the interrelationship
among variables in the simulation.

MONTE CARLO SIMULATION:

BASIC STEPS
Model

the project: express the key

variables and the equations expressing
these key variables and the cash flow.
Specify the probabilities; estimate the
probability distribution of each key
variable.
Assign numbers reflecting the probability
distributions for the key variables.
Simulate the cash flows
Calculate the NPV

INTERNATIONAL RISK
CONSIDERATIONS
MNCs

face risks that are unique

to the international arena.

1.

Exchange Rate Risk

2.

Political Risk

EXCHANGE RATE RISK

Exchange

rate risk is the risk that an

unexpected change in the exchange rate
will reduce the market value of a projects
cash flows.
Dollar value of Future cash inflows may be
dramatically altered.
short term - risk can be hedged by using
financial instruments such as foreign
currency futures and options.
Long-term exchange rate risk can be
minimized by financing the project in
whole or in part in the local currency.

POLITICAL RISK
Much

harder to protect against

Host

country can block repatriation

or even seize assets

Accounting

for these risks can be

accomplished by adjusting the rate
used to discount cash flowsor
betterby adjusting the projects
cash flows.

INTERNATIONAL RISK
CONSIDERATIONS (Cont.)
Impact

of TAXES paid to foreign

governments and the impact of these tax
payments on the parent company
Transfer Pricing: The prices that
subsidiaries charge each other for the
goods and services traded between them.
Since a great deal of cross-border trade
among MNCs takes place between
subsidiaries, it is also important to
determine the net incremental impact
of a projects cash flows overall.

INTERNATIONAL RISK
CONSIDERATIONS (Cont.)

It

is important to
approach international
capital projects from a
strategic viewpoint
rather than from a
strictly financial
perspective.

Risk-Adjusted Discount
Rates
Risk-adjusted

discount rates are

rates of return that must be earned on
given projects to compensate the
firms owners adequatelythat is, to
maintain or improve the firms share
price.
The higher the risk of a project, the
higher the RADRand thus the lower
a projects NPV.

Risk-Adjusted Discount Rates:

Review of CAPM

Risk-Adjusted Discount Rates:

Using CAPM to Find RADRs
Figure 10.2 CAPM and SML

Insert Figure 10.2 here

Risk-Adjusted Discount Rates:

Applying RADRs
Bennett Company wishes to apply the Risk-Adjusted Discount Rate
(RADR) approach to determine whether to implement Project A or
B. In addition to the data presented earlier, Bennetts
management assigned a risk index of 1.6 to project A and 1.0 to
project B as indicated in the following table. The required rates of
return associated with these indexes are then applied as the
discount rates to the two projects to determine NPV.

Risk-Adjusted Discount Rates:

Applying RADRs (cont.)

Risk-Adjusted Discount Rates:

Applying RADRs (cont.)
Figure 10.3 Calculation of NPVs for Bennett Companys Capital
Expenditure Alternatives Using RADRs

Risk-Adjusted Discount Rates:

RADRs in Practice
Table 10.3 Bennett Companys Risk Classes and RADRs

Risk-Adjustment Techniques:
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.

Risk-Adjustment Techniques:
Portfolio Effects (cont.)
It

turns out that firms are not

rewarded for diversification
because investors can do so
themselves.

An

investor can diversify more

readily, easily, and costlessly
simply by holding portfolios of
stocks.

Capital Budgeting Refinements:

Comparing Projects With Unequal
Lives
If

projects are independent, comparing

projects with unequal lives is not
critical.

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.

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.

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.

Capital Budgeting Refinements:

Comparing Projects With Unequal Lives
(cont.)
Ignoring the difference in their useful lives, both projects are acceptable
(have positive NPVs). Furthermore, if the projects were mutually
exclusive, project Y would be preferred over project X. However, it is
important to recognize that at the end of its 3 year life, project Y must
be replaced, or renewed.

Although a number of approaches are available for dealing with

unequal lives, we will present the most efficient technique -- the
annualized NPV approach.

Capital Budgeting Refinements:

Comparing Projects With Unequal Lives
(cont.)
Annualized NPV (ANPV)
The ANPV approach converts the NPV of unequal-lived mutually
exclusive projects into an equivalent (in NPV terms) annual amount that
can be used to select the best project.

1. Calculate the NPV of each project over its live using the
appropriate cost of capital.
2. Divide the NPV of each positive NPV project by the
PVIFA at the given cost of capital and the projects live
to get the ANPV for each project.
3. Select the project with the highest ANPV.

Capital Budgeting Refinements:

Comparing Projects With Unequal Lives
(cont.)
Annualized NPV (ANPV)

1. Calculate the NPV for projects X and Y at 10%.

NPVX = $11,248; NPVY = $18,985.
2. Calculate the ANPV for Projects X and Y.
ANPVX = $11,248/PVIFA10%,3 years = $4,523
ANPVY = $18,985/PVIFA10%,6 years = $4,359
3. Choose the project with the higher ANPV.
Pick project X.

Recognizing Real Options

Real

options are opportunities that

are embedded in capital projects that
enable managers to alter their cash
flows and risk in a way that affects
project acceptability (NPV).

Real

options are also sometimes

referred to as strategic options.

Some

of the more common types of

real options are described in the table
on the following slide.

Recognizing Real Options

(cont.)
Table 10.4 Major Types of Real Options

Recognizing Real Options

(cont.)
NPVstrategic = NPVtraditional + Value of Real Options

Assume that a strategic analysis of Bennett Companys

projects A and B (see Table 10.1) finds no real options
embedded in Project A but two real options embedded
in B:
1. During its first two years, B would have downtime that
results in unused production capacity that could be used
to perform contract manufacturing;
2. Project Bs computerized control system could control two
other machines, thereby reducing labor costs.

Recognizing Real Options

(cont.)
Bennetts management estimated the NPV of the contract manufacturing
option to be $1,500 and the NPV of the computer control sharing option to
be $2,000. Furthermore, they felt there was a 60% chance that the
contract manufacturing option would be exercised and a 30% chance that
the computer control sharing option would be exercised.

Value of Real Options for B =

(60% x $1,500) +

(30% x $2,000)
NPVstrategic

$900 + $600 = $1,500

= $10,924 + $1,500 = $12,424

NPVA = $12,424; NPVB = $11,071; Now choose A

over B.

Capital Rationing
Firms

often operate under conditions of

capital rationingthey 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, research has found that
management internally imposes capital
expenditure constraints to avoid what it
deems to be excessive levels of new
financing, particularly debt.
Thus, the objective of capital rationing is to
select the group of projects within the firms

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. The initial investment and IRR for each
project are shown below:

Capital Rationing: IRR

Approach
Figure 10.4 Investment Opportunities Schedule

Capital Rationing: NPV

Approach
Table 10.5 Rankings for Tate Company Projects

THE END