ACS310: Finance

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ACS310 Finance

• Dealing with Project Risk and Other Topics in
  Capital Budgeting
• (Lecture 14)

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Risk in Capital Budgeting

• Capital projects sometimes have different levels
  of risk than the firms overall level has been.
• Thus far, we have project risk equal to overall
  firm risk.
• In this chapter we relax this assumption and
  examine how to incorporate different levels of
  risk into the capital budgeting process.

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Source of Risk

• Risk the chance that the inputs into the
  analysis of an investment project will prove to
  be wrong.
• GIGO Garbage In, Garbage Out. Poor forecasts
  result in poor decisions no matter how thorough
  the analysis of the numbers.

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Figure 13.1 Calculation of NPV
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Behavioural Approaches to Risk

• Augmenting the analysis of the numbers, there are
  several Behavioural Approaches that can be used
  to get a feel for the level of project risk.

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Risk and Cash Inflows

• Risk is associated with the principal reason for
  investing in a capital budgeting project it
  generates an expected increase in operating
  income.
• Key component of cash flows subject to
  significant risk is Incremental Operating Income.

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Sensitivity and Scenario Analysis

• Sensitivity Analysis uses a number of possible
  values for a given variable to assess its impact
  on a firms return.
• Scenario Analysis evaluates the impact on return
  of simultaneous changes in a number of variables.

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Simulation

• Simulation is a statistically based behavioural
  approach that applies predetermined probability
  distributions and random numbers to estimate
  risky outcomes.
• From a distribution of simulated returns, whether
  NPV or IRR, the decision maker can determine both
  the expected value of the return and the
  probability of achieving it.

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Figure 13.2 NPV Simulations
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International Risk Considerations

• Exchange Rate Risk
• is the danger of unexpected changes in exchange
  rate values that may affect a projects cash
  flows when some portion of those flows are
  denominated in another currency.
• Transfer Prices
• are prices subsidiaries charge each other for
  goods and services traded between them.
• Political risk, international tax issues, and
  strategic marketing relations issues also take
  the decision makers beyond the criteria of
  present value analysis.

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Risk-Adjusted Techniques

• To quantitatively evaluate risky projects, we
  return to the NPV criteria
• (13.2)
• Note that IC occurs at time zero is known with
  certainty, so risk is embodied in the present
  value of the incremental cash flows, CFt, and the
  discount rate, ka.

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Certainty Equivalents (CEs)

• Risk-adjusted factors that represent the percent
  of estimated cash inflow that investors would be
  satisfied to receive for certain rather than the
  cash inflows that are possible for each year.
• (13.4)
• ?t certainty equivalent factor in year t (0??t
  ?1)
• CFt relevant incremental cash inflow in year t
• RF risk-free rate of return
• The risk-free rate of return is used to discount
  the certain cash inflows.

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Risk-Adjusted Discount Rates

• RADR is the rate of return that must be earned on
  a given project to compensate for the risk of the
  project.
• The logic underlying using RADRs is linked to the
  capital asset pricing model CAPM.
• (13.8)

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Applying RADRs

• Any project having an IRR falling on or above the
  security market line (SML) would be acceptable,
  because that IRR would be equal to or greater
  than kproject j.
• Attention is devoted to assessing the total risk
  of a project and using that it to determine the
  risk-adjusted discount rate.

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Figure 13.3 CAPM and SML
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Portfolio Effects

• Benefits such as increased cash flows, borrowing
  capacity, guarantees of raw materials, etc, can
  result from and therefore justify
  diversification.
• CAPM assumes perfect markets imperfections in
  real capital market causes inefficiencies.
• These inefficiencies and difficulties in
  measuring nondiversifiable project risk favour
  the use of total risk to evaluate capital
  budgeting projects.

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Figure 13.4 Risk Index
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Figure 13.5 NPVs using RADRs
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CE vs. RADR in Practice

• Certainty Equivalents are theoretically preferred
  because they separate risk adjustments from
  adjustments of time.
• RADRs are more often used in practice
• They are consistent with focus on rate of return,
• They are easily estimated and applied.
• Firms often separate risk classes with RADR
  assigned to each class to approach distinctions
  made by the CE method.

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Capital Budgeting Refinements

• Three areas requiring special forms of analysis
• Comparison of mutually exclusive projects of
  unequal lives,
• Recognition of real options, and
• Capital rationing caused by a binding budget
  constraint.

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Comparing Projects of Unequal Lives

• When the projects have unequal lives the
  assessment of time values must be adjusted.
• Annualized Net Present Value (ANPV) converts NPV
  of unequal-lived projects into an equivalent
  annual amount that can be used to select the best
  project.
• (13.9)

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Recognizing Real Options

• Real Options 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). Also called
  Strategic Options.
• (13.10) NPVstrategic NPVj value of real
  options

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Major Types of Real Options

• Abandonment Option to abandon or terminate prior
  to end of planned life.
• Flexibility Option to adopt a flexible approach
  in firms operations, like production.
• Growth Option to develop follow-on projects,
  expand markets, plant, operations and so on.
• Timing Option to determine when various actions
  are taken.

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Capital Rationing

• Theory capital rations should not exit.
• Practice firms operate under capital rationing.
• The Objective of capital rationing is to select
  the group of projects that provide the highest
  overall net present value and does not require
  more dollars than are budgeted.
• Ranking projects by IRR and investment cost
  managers can select the total number of projects
  they can afford.

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Capital Budget Example

• What can you afford with a Capital Budget of
  25,000?
• Which projects will you adopt?