Professional Documents
Culture Documents
Capital Budgeting
and Risk Analysis
CHAPTER ORIENTATION
The focus of this chapter will be on how to adjust for the riskiness of a given project or
combination of projects.
CHAPTER OUTLINE
I.
II.
Up to this point we have treated the expected cash flows resulting from an
investment proposal as being known with perfect certainty. We will now
introduce risk.
B.
First, there is the project standing alone risk, which is a projects risk
ignoring the fact that much of this risk will be diversified away as the
project is combined with the firms other projects and assets.
2.
3.
Finally, there is systematic risk, which is the risk of the project from
the viewpoint of a well-diversified shareholder; this measure considers
the fact that some of a projects risk will be diversified away as the
project is combined with the firms other projects, and, in addition,
some of the remaining risk will be diversified away by shareholders as
they combine this stock with other stocks in their portfolio.
34
B.
III.
In effect, a riskless set of cash flows is substituted for the original set
of risky cash flows, between which the financial manager is indifferent.
2.
3.
4.
5.
Once risk is taken out of the cash flows, those cash flows are
discounted back to present at the risk-free rate of interest and the
project's net present value or profitability index is determined.
6.
7.
NPV
t 1
where t
t FCFt
- IO
(1 k rf ) t
FCFt =
IO
krf
35
B.
The use of the risk-adjusted discount rate is based on the concept that
investors demand higher returns for more risky projects.
1.
If the risk associated with the investment is greater than the risk
involved in a typical endeavor, then the discount rate is adjusted
upward to compensate for this risk.
2.
The expected cash flows are then discounted back to present at the
risk-adjusted discount rate. Then the normal capital budgeting criteria
are applied, except in the case of the internal rate of return, in which
case the hurdle rate to which the project's internal rate of return is
compared now becomes the risk-adjusted discount rate.
3.
NPV
t 1
where FCFt
IV.
FCFt
(1 k*) t
- IO
IO
k*
Theoretically, we know that systematic risk is the "priced" risk, and thus, the
risk that affects the stock's market price and thus the appropriate risk with
which to be concerned. However, if there are bankruptcy costs (which are
assumed away by the CAPM), if there are undiversified shareholders who are
concerned with more than just systematic risk, if there are factors that affect a
security's price beyond what the CAPM suggests, or if we are unable to
confidently measure the project's systematic risk, then the project's individual
risk carries relevance. Moreover, in general, a project's individual risk is
highly correlated with the project's systematic risk, making it a reasonable
proxy to use.
B.
C.
If the project is not a typical project, we are without historical data and must
either estimate the beta using accounting data or use the pure-play method for
estimating beta.
1.
36
V.
B.
VI.
The pure play method for estimating a project's beta: The pure play
method attempts to find a publicly traded firm in the same industry as
the capital-budgeting project. Once the proxy or pure-play firm is
identified, its systematic risk is determined and then used as a proxy
for the project's systematic risk.
2.
b.
Many times, especially with the introduction of a new product, the cash flows
experienced in early years affect the size of the cash flows experienced in later
years. This is called time dependence of cash flows, and it has the effect of
increasing the riskiness of the project over time.
ANSWERS TO
END-OF-CHAPTER QUESTIONS
11-1. The payback period method is frequently used as a rough risk screening device to
eliminate projects whose returns do not materialize until later years. In this way, the
earliest returns are emphasized, which in all likelihood have less uncertainty
surrounding them.
37
11-2. The use of the risk-adjusted discount rate assumes that risk increases over time.
When using the risk-adjusted discount rate method, we are adjusting downward the
value of future cash flows that occur later in the future more severely than earlier
ones. This assumption can be justified because flows that are expected further out in
the future are more difficult to forecast and less certain than are flows that are
expected in the near future.
11-3. The primary difference between the certainty equivalent approach and the riskadjusted discount rate approach is where the adjustment for risk is incorporated into
the calculations. The certainty equivalent approach penalizes or adjusts downwards
the value of the expected annual free cash flows, while the risk-adjusted discount rate
leaves the cash flows at their expected value and adjusts the required rate of return, k,
upwards to compensate for added risk. In either case the net present value of the
project is being adjusted downwards to compensate for additional risk. An additional
difference between these methods is that the risk-adjusted discount rate assumes that
risk increases over time and that cash flows occurring later in the future should be
more severely penalized. The certainty equivalent method, on the other hand, allows
each cash flow to be treated individually.
11-4. A probability tree is a graphical exposition of the sequence of possible outcomes,
presenting the decision maker with a schematic representation of the problem in
which all possible outcomes are graphically displayed. Moreover, the computations
and results of the computations are shown directly on the tree, so that the information
can be easily understood. Thus the probability tree allows the manager to quickly
visualize the possible future events, their probabilities, and outcomes. In addition, the
calculation of the expected internal rate of return and enumeration of the distribution
should aid the financial manager in his decision-making process.
11-5. The idea behind simulation is to imitate the performance of the project being
evaluated. This is done by randomly selecting observations from each of the
distributions that affect the outcome of the project, combining each of those
observations and determining the final outcome of the project, and continuing with
this process until a representative record of the project's probable outcome is
assembled. In effect, the output from a simulation is a probability distribution of net
present values or internal rates of return for the project. The decision maker then
bases his decision on the full range of possible outcomes.
11-6. The time dependence of cash flows refers to the fact that, many times, cash flows in
later periods are dependent upon the cash flows experienced in earlier periods. For
example, if a new product is introduced and the initial public reaction is poor,
resulting in low initial cash flows, then cash flows in future periods are likely to be
low also. Examples include the introduction of any new products, for example, the
Edsel on the negative side, and hopefully this book on the positive side.
38
SOLUTIONS TO
END-OF-CHAPTER PROBLEMS
Solutions to Problem Set A
n
11-1A. (a)
i 1
XA
Xi P(Xi)
XB
(b)
NPV
t 1
NPVA
FCFt
- I0
(1 k*) t
NPVB
(c)
One might also consider the potential diversification effect associated with
these projects. If the project's cash flow patterns are cyclically divergent from
those of the company, the overall risk of the company may be significantly
reduced.
39
11-2A. (a)
i 1
XA
Xi P(Xi)
XB
(b)
NPV
t 1
NPVA
FCFt
- IO
(1 k*) t
NPVB
(c)
= $58,265
One might also consider the potential diversification effect associated with
these projects. If the project's cash flow patterns are cyclically divergent from
those of the company, the overall risk of the company may be significantly
reduced.
11-3A.
Project A:
(A)
Year
0
1
2
3
4
Expected
Cash Flow
-$1,000,000
500,000
700,000
600,000
500,000
(B)
t
1.00
.95
.90
.80
.70
(A x B)
Present Value
(Expected
Factor at
Present
Cash Flow ) (t)
5%
Value
-$1,000,000
1.000
-$1,000,000
475,000
.952
452,200
630,000
.907
571,410
480,000
.864
414,720
350,000
.823
288,050
NPVA = $ 726,380
40
Project B:
(A)
(B)
(A x B)
Present Value
Year
0
1
2
3
4
Expected
Cash Flow
-$1,000,000
500,000
600,000
700,000
800,000
t
1.00
.90
.70
.60
.50
(Expected
Cash Flow ) (t)
-$1,000,000
450,000
420,000
420,000
400,000
Factor at
Present
5%
Value
1.000
-$1,000,000
.952
428,400
.907
380,940
.864
362,880
.823
329,200
NPVB = $ 501,420
(B)
(A x B)
Present Value
Year
0
1
2
3
4
5
Expected
Cash Flow
-$90,000
25,000
30,000
30,000
25,000
20,000
t
1.00
0.95
0.90
0.83
0.75
0.65
(Expected
Cash Flow ) (t)
-$90,000
23,750
27,000
24,900
18,750
13,000
Factor at
Present
7%
Value
1.000
-$90,000
.935
22,206
.873
23,571
.816
20,318
.763
14,306
.713
9,269
NPV = $ -330
Thus, this project should not be accepted because it has a negative NPV.
11-5A.
NPVA
t 1
FCFt
- I0
(1 k*) t
t 1
FCF
- I0
(1 k*) t
= $135,000(3.127) - $400,000
= $422,145 - $400,000
41
= $22,145
42
11-6A.
Project A:
(A)
Year
0
1
2
3
4
Expected
Cash Flow
-$ 50,000
15,000
15,000
15,000
45,000
(B)
t
1.00
.95
.85
.80
.70
(A x B)
(Expected
Cash Flow ) (t)
-$ 50,000
14,250
12,750
12,000
31,500
Present Value
Factor at
Present
6%
Value
1.000
-$ 50,000.00
.943
13,437.75
.890
11,347.50
.840
10,080.00
.792
24,948.00
NPVA = $ 9,813.25
Project B:
(A)
Year
0
1
2
3
4
Expected
Cash Flow
-$ 50,000
20,000
25,000
25,000
30,000
(B)
t
1.00
.90
.85
.80
.75
(A x B)
(Expected
Cash Flow ) (t)
-$ 50,000
18,000
21,250
20,000
22,500
Present Value
Factor at
Present
6%
Value
1.000
-$ 50,000.00
.943
16,974.00
.890
18,912.50
.840
16,800.00
.792
17,820.00
NPVB = $ 20,506.50
43
1 Year
2 Years
Probability
(A)(B)
$300,000
-12.95%
0.18
-2.33%
$700,000
10.92%
0.36
3.93%
$1,100,000
29.25%
0.06
1.76%
$400,000
3.15%
0.06
0.19%
$700,000
19.60%
0.15
2.94%
$1,000,000
33.33%
0.06
2.00%
$1,300,000
45.36%
0.03
1.36%
$600,000
23.74%
0.01
0.24%
$900,000
37.77%
0.05
1.89%
$1,100,000
46.08%
0.04
1.84%
p = 0.3
p = 0.6
$700,000
Joint
each Branch
P = 0.1
p = 0.6
p = 0.2
p = 0.5
299
p = 0.3
- $1,200,000
p = 0.2
$850,000
p = 0.1
p = 0.1
p = 0.1
p = 0.5
$1,000,000
p = 0.4
1.00
Expected internal rate of return
d.
13.82%
11-7A. (a
c)
Internal Rate
of Return for
0 Year
1 Year
2 Years
3 Years
p = 0.5
Internal Rate
Joint
each Branch
Probability
(A)(B)
$230,000
130.25%
0.09
11.72%
$180,000
124.68%
0.09
11.22%
$205,000
121.09%
0.15
18.16%
$155,000
114.96%
0.15
17.24%
$180,000
111.30%
0.06
6.68%
$130,000
104.46%
0.06
6.27%]
$10,000
-42.44%
0.24
-10.19%
$0
-90.00%
0.16
-14.40%
p = 0.5
$200,000
p = 0.3
p = 0.5
p = 0.5
p = 0.5
300
$175,000
p = 0.6
$100,000
p = 0.2
p = 0.5
$-100,000
p = 0.5
$150,000
p = 0.4
p = 1.0
p = 0.6
$10,000
$10,000
p = 1.0
p = 0.4
$0
d.
1.00
Expected internal rate of return
46.70%
11-8A. (a
c)
of Return for
0 Year
First there is the project standing alone risk, which is a project's risk ignoring the fact
that much of this risk will be diversified away as the project is combined with the
firm's other projects and assets. Second, we have the project's contribution-to-firm
risk, which is the amount of risk that the project contributes to the firm as a whole;
this measure considers the fact that some of the project's risk will be diversified away
as the project is combined with the firm's other projects and assets, but ignores the
effects of diversification of the firm's shareholders. Finally, there is systematic risk,
which is the risk of the project from the viewpoint of a well diversified shareholder;
this measure considers the fact that some of a project's risk will be diversified away as
the project is combined with the firm's other projects, and, in addition, some of the
remaining risk will be diversified away by the shareholders as they combine this stock
with other stocks in their portfolio.
2.
According to the CAPM, systematic risk is the only relevant risk for capital budgeting
purposes; however, reality complicates this somewhat. In many instances a firm will
have undiversified shareholders; for them the relevant measure of risk is the project's
contribution to firm risk. The possibility of bankruptcy also affects our view of what
measure of risk is relevant. Because the project's contribution to firm risk can affect
the possibility of bankruptcy, this may be an appropriate measure of risk since there
are costs associated with bankruptcy.
3.
The primary difference between the certainty equivalent approach and the riskadjusted discount rate approach is where the adjustment for risk is incorporated into
the calculations. The certainty equivalent approach penalizes or adjusts downwards
the value of the expected annual free cash flows, while the risk-adjusted discount rate
leaves the cash flows at their expected value and adjusts the required rate of return, k,
upwards to compensate for added risk. In either case the net present value of the
project is being adjusted downwards to compensate for additional risk. An additional
difference between these methods is that the risk-adjusted discount rate assumes that
risk increases over time and that cash flows occurring later in the future should be
more severely penalized. The certainty equivalent method, on the other hand, allows
each cash flow to be treated individually.
4.
5.
The idea behind simulation is to imitate the performance of the project being
evaluated. This is done by randomly selecting observations from each of the
distributions that affect the outcome of the project, combining each of those
40
observations and determining the final outcome of the project, and continuing with
this process until a representative record of the project's probable outcome is
assembled. In effect, the output from a simulation is a probability distribution of net
present values or internal rates of return for the project. The decision maker then
bases his decision on the full range of possible outcomes.
6.
Sensitivity analysis involves determining how the distribution of possible net present
values or internal rates of return for a particular project is affected by a change in one
particular input variable. This is done by changing the value of one input variable
while holding all other input variables constant.
7.
The time dependence of cash flows refers to the fact that, many times, cash flows in
later periods are dependent upon the cash flows experienced in earlier periods. For
example, if a new product is introduced and the initial public reaction is poor,
resulting in low initial cash flows, then cash flows in future periods are likely to be
low also. Examples include the introduction of any new products, for example, the
Edsel on the negative side, and hopefully this book on the positive side.
8.
Project A:
(A)
(B)
(A x B)
Present Value
Expected
Cash Flow
Year
0
1
2
3
4
-$150,000
40,000
40,000
40,000
100,000
(Expected
Cash Flow ) (t)
Factor at
7%
1.00
.90
.85
.80
.70
-$150,000
36,000
34,000
32,000
70,000
1.000
.935
.873
.816
.763
(B)
(A x B)
Present
Value
-$150,000
33,660
29,682
26,112
53,410
NPVA = - $ 7,136
Project B:
(A)
0
1
2
3
4
Expected
YearCash Flow
-$200,000
50,000
60,000
60,000
50,000
t
1.00
.95
.85
.80
.75
(Expected
Cash Flow ) (t)
-$200,000
47,500
51,000
48,000
37,500
Present Value
Factor at
Present
7%
Value
1.000
-$200,000
.935
44,413
.873
44,523
.816
39,168
.763
28,613
NPVB = - $ 43,283
Thus, neither project should be selected, as they both have negative NPVs.
41
1 Year
Joint
each Branch
2 Years
p = 0.3
Probability
(A)(B)
$200,000
-12.08%
0.12
-1.45%
$300,000
0.00%
0.28
0.00%
$250,000
0.00%
0.08
0.00%
$450,000
20.55%
0.20
4.11%
$650,000
37.26%
0.12
4.47%
$300,000
17.54%
0.04
0.70%
$500,000
36.19%
0.10
3.62%
$700,000
51.84%
0.04
2.07%
$1,000,000
71.94%
0.02
1.44%
p = 0.7
$300,000
p = 0.4
p = 0.2
p = 0.5
298
p = 0.4
-$600,000
p = 0.3
$350,000
p = 0.2
p = 0.2
p =0.5
p = 0.2
$450,000
p = 0.1
1.00
Expected internal rate of return
The range of possible IRRs from -12.08% to 71.94%.
14.96%
Part 9
Internal Rate
of Return for
0 Year
11-1B. (a)
Xi P(Xi)
i 1
A =
$6,000
B =
$7,000
n
(b)
NPV
t 1
NPVA =
$21,102 - $10,000
$11,102
NPVB =
(c)
FCFt
- I0
(1 k*) t
$21,889 - $10,000
$11,889
One might also consider the potential diversification effect associated with
these projects. If the project's cash flow patterns are cyclically divergent
from those of the company, the overall risk of the company may be
significantly reduced.
43
11-2B. (a)
i 1
A =
Xi P(Xi)
$47,500
B =
$55,000
n
(b)
NPV
t 1
NPVA =
$175,560 - $125,000
$50,560
NPVB =
(c)
FCFt
- I0
(1 k*) t
$193,435 - $125,000
$68,435
One might also consider the potential diversification effect associated with
these projects. If the project's cash flow patterns are cyclically divergent
from those of the company, the overall risk of the company may be
significantly reduced.
44
11-3B.
Project A:
(A)
(B)
(A x B)
Present Value
Year
0
1
2
3
4
Expected
Cash Flow
-$100,000
600,000
750,000
600,000
550,000
t
1.00
.90
.90
.75
.65
(Expected
Cash Flow ) (t)
-$100,000
540,000
675,000
450,000
357,500
Factor at
Present
5%
Value
1.000
-$100,000
.952
514,080
.907
612,225
.864
388,800
.823
294,222.50
NPVA = $ 1,709,327.50
Project B:
(A)
Year
0
1
2
3
4
Expected
Cash Flow
-$100,000
600,000
650,000
700,000
750,000
(B)
(A x B)
t
1.00
.95
.75
.60
.60
(Expected
Cash Flow ) (t)
-$100,000
570,000
487,500
420,000
450,000
Present Value
Factor at
Present
5%
Value
1.000
-$100,000
.952
542,640
.907
442,162.50
.864
362,880
.823
370,350
NPVB = $1,618,032.50
(B)
Year
0
1
2
3
4
5
Expected
Cash Flow
-$100,000
30,000
25,000
30,000
20,000
25,000
(A x B)
t
1.00
0.95
0.90
0.83
0.75
0.65
Present Value
(Expected
Factor at
Present
Cash Flow ) .( t)
8%
Value
-$100,000
1.000
-$100,000
28,500
.926
26,391
22,500
.857
19,283
24,900
.794
19,771
15,000
.735
11,025
16,250
.681
11,066
NPV = -$ 12,464
Thus, this project should not be accepted because it has a negative NPV.
45
11-5B.
NPVA
FCFt
- IO
(1 k*) t
t 1
=
NPVB
- $93,280
n
t 1
FCF
- IO
(1 k*) t
$130,000(3.127) - $450,000
$406,510 - $450,000
-$43,490
11-6B.
Project A:
(A)
Year
0
1
2
3
4
Expected
Cash Flow
-$ 75,000
20,000
20,000
15,000
50,000
(B)
t
1.00
.95
.85
.80
.70
(A x B)
(Expected
Cash Flow ) x (t)
-$ 75,000
19,000
17,000
12,000
35,000
Present Value
Factor at
Present
7%
Value
1.000
-$ 75,000.00
.935
17,765.00
.873
14,841.00
.816
9,792.00
.763
26,705.00
NPVA = ($ 5,897.00)
Project B:
(A)
Year
0
1
2
3
4
Expected
Cash Flow
-$ 75,000
25,000
30,000
30,000
25,000
(B)
t
(A x B)
(Expected
Cash Flow ) x (t)
1.00
.95
.85
.80
.75
-$ 75,000
23,750
25,500
24,000
18,750
Factor at
7%
Present Value
Present
Value
1.000
-$ 75,000.00
.935
22,206.25
.873
22,261.50
.816
19,584.00
.763
14,306.25
NPVB = $ 3,358.00
1 Year
2 Years
Probability
(A)(B)
$300,000
-15.12%
0.06
-0.9072%
$700,000
7.69%
0.30
2.3070%
$1,100,000
25.25%
0.24
6.0600%
$400,000
0.00%
0.06
0.0000%
$700,000
15.75%
0.15
2.3625%
$900,000
24.73%
0.06
1.4838%]
$1,300,000
40.44%
0.03
1.2132%
$600,000
46.82%
0.03
1.4046%
$900,000
58.94%
0.06
3.5364%
$1,100,000
66.27%
0.01
1.00
Expected internal rate of return
0.6627%
p = 0.1
p = 0.5
$750,000
p = 0.4
p = 0.6
p = 0.2
303
-$1,300,000
p = 0.5
p = 0.3
p = 0.2
$900,000
p = 0.1
p = 0.1
p = 0.3
p = 0.6
$1,500,000
(d)
p = 0.1
18.1230%
11-7B. (a
c)
of Return for
0 Year
Internal Rate
Joint
each Branch
1 Year
2 Years
3 Years
p = 0.5
Probability
(A)(B)
$255,000
115.83%
.105
12.16227%
$205,000
110.76%
.105
11.6298%
$210,000
101.15%
.175
17.7013%
$160,000
95.18%
.175
16.6565%
$170,000
86.57%
.070
6.0599%
$120,000
79.42%
.070
5.5594%
$10,000
-46.70%
.180
-8.4060%
$0
-91.67%
.120
-11.0004%
p = 0.5
$225,000
p = 0.3
p = 0.5
p = 0.5
p = 0.5
$180,000
p = 0.2
p = 0.7
304
$100,000
p = 0.5
-$120,000
p = 0.5
$140,000
p = 0.3
p = 1.0
p = 0.6
$10,000
$10,000
p = 1.0
p = 0.4
$0
1.00
Expected internal rate of return
(d)
50.3627%
11-8B. (a
c)
of Return for
0 Year
Internal Rate
Joint
each Branch
To force the student to recognize the role ethical behavior plays in all
areas of Finance.
DEGREE OF DIFFICULTY:
Easy
Case Solution:
With ethics cases there are no right or wrong answers - just opinions. Try to bring out as
many opinions as possible without being judgmental. In this case the question centers
around what to do when a product is no longer salable.
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