Contribution

to Total Firm
Risk:
Firm Portfolio Approach
Saliwan, James Drixler Evidor
When multiple investment
projects are involved, we
may want to study their
combined risk
The approach will take is

the portfolio approach to

capital investment projects
The purpose of this is to
show how to measure risk
for combination of risky
investments, assuming
that such a measure is
desired.
If firm adds a project
whose future cash flows
are likely to be highly
correlated with those of
existing assets, the total
risk of the firm will
increase more than if it
adds a project that has a
low degree of correlation
Given this reality, a firm
might wish to seek out
projects that could be
combined to reduce
relative firm risk
Thisfigure shows the
expected cash flow
patterns for two project
over time. Proposal A is
cyclical, whereas proposal
B is countercyclical
 Combining projects in this manner
reduces the firm risk due to
diversification.
Combination of
Proposal A Proposal B
Proposals A and B
CASH FLOW

TIME TIME TIME

And the principle is same as for

diversification of securities
Determining
Determining the
the Expected
Expected
NPV
NPV for
for a
a Portfolio
Portfolio of
of Projects
Projects
m

NPVP = ( NPVj )
j=1

NPVP is the expected portfolio NPV,

NPVj is the expected NPV of the jth
NPV that the firm undertakes,
m is the total number of projects in
the firm portfolio.
 Determining Portfolio
Standard Deviation
m m
P = jk
j=1 k=1

jk is the covariance between possible NPVs for

projects j and k

jk = j k rjk .

j is the standard deviation of project j,

k is the standard deviation of project k,
rjk is the correlation coefficient between
projects j and k.
Toillustrate these concepts,
suppose that a firm has a
single existing investment
project 1 and that it is
considering investing in an
additional project 2. Assume
further that the projects have
the following expected values
of NPV, SD, and CC
 EXPECTED STANDARD CORRELATIO
VALUE OF DEVIATION N
NET COEFFICIENT
PRESENT
VALUE

Project 1 12,000 14,000 BETWEEN 1

AND 2 0.40

Project 2 8,000 6,000

COMBINATIO
N OF RISKY
INSTRUMENT
We will assume that the firm
has existing investment
projects and this project will
generate cash flow. Thus
existing projects constitute a
subset that is included in all
potential future
combinations. We denote the
portfolio of existing projects
by LETTER E
 Combinations of
Risky Investments
E: Existing Projects C
8 Combinations

Expected Value of NPV

B

E E+1 E+1+2
E
E+2 E+1+3
E+3 E+2+3
E+1+2+3 A

A, B, and C are
dominating combinations
Standard Deviation
from the eight possible.