CHAPTER 11:

CAPITAL
BUDGETING AND
RISK ANALYSIS
Prepared By:
Maica Santos
Cindy Peralta
1. Explain what the appropriate measure of risk is for
capital-budgeting purposes.
2. Determine the acceptability of a new project using
both the certainty equivalent and risk-adjusted
discount rate methods of adjusting for risk.
3. Explain the use of simulation and probability trees
for imitating the performance under evaluation.
RISK AND THE
INVESTMENT DECISION

There are two (2) basic issues:

1. What is risk in terms of capital-budgeting decisions,
how should it be measured?
2. How should risk be incorporated into capital budgeting
analysis?
THREE MEASURES OF
RISK

1. Project standing alone risk- it is measured by

the variability of the asset’s expected returns.
2. Project’s contribution- to- firm risk- the
amount of risk that a project contributes to
the firm as a whole.
3. Systematic risk- the risk of a project
measured from the point of view of a well-
diversified shareholder.
METHODS FOR INCORPORATING
RISK INTO CAPITAL-BUDGETING

1. Certainty Equivalent- under this method, the

decision maker substitutes a set of equivalent
riskless cash flows for the expected cash flows
and then discounts these cash flows back to
the present.
2. Risk-adjusted discount rate- in this method, the
discount rate is adjusted to compensate for
risk.
 Sample problem: Certainty
equivalent
ZERO Corporation is studying the long-term impact of the two
projects and has gathered the following data for analysis:

A CE B CE
IO 20,000 factor
100% 12,000 factor
100%
CI
1 16,000 95% 8,000 94%
2 8,000 92% 5,000 83%
3 6,000 86% 4,000 80%
4 0 5,000 70%
5 0 4,000 60%
Discount 12% 14%
rate
Sample problem. Risk-adjusted
discount rate
Project A Project B
IO 20,000 12,000
Cash Inflows
1 16,000 8,000
2 8,000 5,000
3 6,000 4,000
4 0 5,000
5 0 4,000
Discount rate 12% 14%
Coefficient of 5% 20%
variation
Risk-adjusted 12.6% 16.8%
discount rate