Chapter 9

Capital Budgeting Under Risk

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McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
 9.1 INTRODUCTION
• Risk analysis is important in making capital
investment decisions because of the large
amount of capital involved and the long-term
nature of the investments being considered.
• The higher the risk associated with a proposed
project, the greater the rate of return that
must be earned on the project to compensate
for that risk.
9.2 MEASURES OF RISK
EXAMPLE 9.1
EXAMPLE 9.1
 9.3 RISK ANALYSIS IN CAPITAL
BUDGETING
• Since different investment projects involve
different risks, it is important to incorporate risk
into the analysis of capital budgeting.
• There are several methods for incorporating risk,
including:
1. Probability distributions
2. Risk-adjusted discount rate
3. Certainty equivalent
4. Simulation
5. Sensitivity analysis
6. Decision trees (or probability trees)
 Probability Distributions
• Expected values of a probability distribution
may be computed.
• Before any capital budgeting method is
applied, compute the expected cash inflows
or, in some cases, the expected life of the
asset.
EXAMPLE 9.2
EXAMPLE 9.2
 Risk-Adjusted Discount Rate
• This method of risk analysis adjusts the cost of capital
(or discount rate) upward as projects become riskier.
• Therefore, by increasing the discount rate from
10percent to 15percent, the expected cash flow from
the investment must be relatively larger or the
increased discount rate will generate a negative NPV,
and the proposed acquisition/investment would be
turned down.
• The use of the risk-adjusted discount rate is based on the
assumption that investors demand higher returns for riskier
projects. The expected cash flows are discounted at the
risk-adjusted discount rate and then the usual capital
budgeting criteria such as NPV and IRR are applied.
EXAMPLE 9.3
 Certainty Equivalent
• The certainty equivalent approach to risk analysis is
drawn directly from the concept of utility theory.
• This method forces the decision maker to specify at
what point the firm is indifferent to the choice
between a certain sum of money and the expected
value of a risky sum.
• Once certainty equivalent coefficients are obtained, they are
multiplied by the original cash flow to obtain the equivalent
certain cash flow.
• Then, the accept-or-reject decision is made, using the
normal capital budgeting criteria.
• The risk-free rate of return is used as the discount rate
under the NPV method and as the cutoff rate under the IRR
method.
EXAMPLE 9.4
 Simulation
• This risk analysis method is frequently called
the Monte Carlo simulation.
• It requires that a probability distribution be
constructed for each of the important
variables affecting the project’s cash flows.
• Since a computer is used to generate many
results using random numbers, project
simulation is expensive.
 Sensitivity Analysis
• Forecasts of many calculated NPVs under
various alternative functions are compared to
see how sensitive NPV is to changing
conditions.
• It may be found that a certain variable or
group of variables, once their assumptions are
changed or relaxed, drastically alters the NPV.
• This results in a much riskier asset than was
originally forecast.
 Decision Trees
• A decision tree is a graphical method of showing the
sequence of possible outcomes.
• A capital budgeting tree would show the cash flows and NPV
of the project under different possible circumstances.
• The decision tree method has the following advantages:
• It visually lays out all the possible outcomes of the proposed
project and makes management aware of the adverse
possibilities, and
• The conditional nature of successive years’ cash flows can be
expressly depicted.
• The primary disadvantage is that most problems are too
complex to permit a year-by-year depiction.
EXAMPLE 9.5
EXAMPLE 9.5
9.4 CORRELATION OF CASH FLOWS
OVER TIME
• When cash inflows are independent from
period to period, it is fairly easy to measure
the overall risk of an investment proposal.
• In some cases, however, especially with the
introduction of a new product, the cash flows
experienced in early years affect the size of the
cash flows in later years.
• This is called the time dependence of cash
flows, and it has the effect of increasing the
risk of the project over time.
EXAMPLE 9.6
9.5 NORMAL DISTRIBUTION AND NPV ANALYSIS:
STANDARDIZING THE DISPERSION
EXAMPLE 9.7
EXAMPLE 9.7
9.6 PORTFOLIO RISK AND THE CAPITAL
ASSET PRICING MODEL (CAPM)
• Portfolio considerations play an important role
in the overall capital budgeting process.
• Through diversification, a firm can stabilize
earnings, reduce risk, and thereby increase the
market price of the firm’s stock.
 Beta Coefficient
• The capital asset pricing model (CAPM) can be used to
determine the appropriate cost of capital.
• The NPV method uses the cost of capital as the rate to
discount future cash flows.
• The IRR method uses the cost of capital as the cutoff
rate.
• The required rate of return, or cost of capital according
to the CAPM, or security market line (SML), is equal to
the risk-free rate of return (rf) plus a risk premium
equal to the firm’s beta coefficient (b)times the market
risk premium (rm-rf):
rj = rf + β(rm-rf)
 EXAMPLE 9.8

The project should be accepted since its NPV is positive, that is, $78. Also, the
project’s IRR can be computed by trial and error. It is almost 30 percent, which
exceeds the cost of capital of 15percent. Therefore, by that standard also the project
should be accepted.
 Calculation of Beta Coefficient
• In measuring an asset’s systematic risk, beta,
an indication is needed of the relationship
between the asset’s returns and the market
returns (such as returns on the Standard &
Poor’s 500 Stock Composite Index). This
relationship can be statistically computed by
determining the regression coefficient
between asset and market returns.
• The method is presented below.
Calculation of Beta Coefficient
EXAMPLE 9.9