978-1259277160 Chapter 13 Lecture Note

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Risk and Capital Budgeting

Author’s Overview

Though risk is discussed throughout the text, Chapter 13 provides the most explicit portrayal of

its impact on the decision-making process of the firm. The actual measurement of risk through

the computation of the mean, standard deviation, and coefficient of variation is presented in

detail. The introduction of the risk-adjusted discount rate brings together the key material in

Chapter 12 and this chapter. Simulation analysis also is introduced to emphasize how

complicated decision variables can be reduced to a more manageable scale through examining,

in advance, outcomes and probabilities of outcomes. Decision trees are introduced after

simulation models to path dependent outcomes combined with probability estimates. Finally, the

portfolio effect of an investment is introduced. The coefficient of correlation is defined in a

general sense that should prove quite workable to the student. An example of the efficient

frontier is demonstrated in Figure 13-11 titled “Risk-Return Trade-Offs.”

Chapter Concepts

LO1. The concept of risk is based on uncertainty about future outcomes. It requires the

computation of quantitative measures as well as qualitative considerations.

LO2. Most investors are risk averse, which means they dislike uncertainty.

LO3. Because investors dislike uncertainty, they will require higher rates of return from risky

projects.

LO4. Simulation models and decision trees can be used to help assess the risk of an

investment.

LO5. Not only must the risk of an individual project be considered, but also how the project

affects the total risk of the firm.

Annotated Outline and Strategy

I. Definitions of Risk in Capital Budgeting

A. Management’s ability to achieve the goal of owner’s wealth maximization will

largely depend on success in dealing with risk.

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B. Definition: Variability of possible outcomes. The wider the distribution of

possible outcomes for a particular investment, the greater is its risk.

C. Risk aversion is a basic assumption of financial theory. Investors require a higher

expected return the riskier an investment is perceived to be.

II. The Concept of Risk Averse

Perspective 13-1: We provide a brief statistical but most students should not have to spend

too much time on the statistics. Instead, focus on applying these measures to financial decision

making.

PPT Variability and Risk (Figure 13-1)

A. The basic risk measurement is the standard deviation, which is a measure of

dispersion around an expected value.

1. The expected value is a weighted average of the possible outcomes of an

event times their probabilities.

2. The formula for computing the standard deviation is:

B. The Coefficient of Variation

1. The standard deviation is limited as a risk measure for comparison

purposes. Two projects A and B may both be characterized by a standard

deviation of $10,000 but A may have an expected value of $50,000 and B

$100,000.

2. The size problem is eliminated by employing the coefficient of variation,

V, which is the ratio of the standard deviation of an investment to its

expected value. The higher the coefficient of variation, the higher the risk.

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(expected value) =

D DnPn

–

(standard deviation) = ( )

Dn D Pns

–

$10,000 $10,000

.20 .10

$50,000 $100,000

A B

V V

= = = =

PPT Probability distribution with differing degrees of risk (Figure 13-3)

C. Beta () is another measure of risk that is widely used in portfolio management.

Beta measures the volatility of returns on an individual stock relative to a stock

market index of returns. (See Appendix 11A for a thorough discussion.)

PPT Betas for a five-year period (ending February 2015) (Table 13-2)

Perspective 13-2: Table 13-2 allows for a good discussion of industry/company factors that

may cause risk.

III. Risk and the Capital Budgeting Process

A. The expected inflows from capital projects are usually risky and uncertain.

B. Cash flows of projects bearing a normal amount of risk undertaken by the firm

should be discounted at the cost of capital.

C. As the risk of a proposal increases, the rate of return required by lenders and

investors increases.

D. The cost of capital is composed of two components: the risk free rate the inflation

adjusted real rate of return) plus a risk premium (risk associated with usual

projects of a business).

E. Adjustments must be made in the evaluation process for projects bearing other

than (more or less) normal risk levels.

1. Risk-adjusted discount rate approach: The discount rate is adjusted

upward for a more risky project and downward for projects bearing less

than normal risk. A firm may establish a risk-adjusted discount rate for

each of various categories of investment such as new equipment, new

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Coefficient of variation ( ) VD

market, etc.

2. Risk adjusted discount rates may be based on several measures of risk

such as: the standard deviation, coefficient of variation or beta.

PPT Relationship of Risk to Discount Rate (Figure 13-5)

Perspective 13-3: Discuss foreign projects and how they are evaluated based on risk.

International capital budgeting often has higher risks associated with emerging market systems

or political instability.

F. Increasing risk over time: Our ability to forecast diminishes as we forecast farther

out in time. See Figure 13-6 on page 425.

G. Qualitative measures may mean that management makes up various risk classes

for projects having similar characteristics.

PPT Risk Categories and Associated Discount Rates (Table 13-3)

PPT Capital Budgeting Analysis (Table 13-4)

Finance in Action: Energy: A High Risk Industry

The focus of the discussion should be on the risk assigned by energy companies to the many

variable that affect cash flow such as: the uncertainty of oil prices, the adoption of alternative

energy sources, government regulations, political turmoil in the Middle East, oil spills, and dry

wells. Consider the collapse of oil prices during the 2015-16 period due to oversupply and an

unwillingness of Saudi Arabia to agree with OPEC to lower production to keep price up.

Perspective 13-4: Tables 13-4 and 13-5 bring back investments A and B from Chapter 12 and

demonstrate how a different decision would be made if Investment B had been adjusted for risk.

PPT Capital Budgeting Decision Adjusted for Risk (Table 13-5)

IV. Simulation Models

A. The uncertainty associated with a capital budgeting decision may be reduced by

projecting and preparing for the various possible outcomes resulting from the

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decision. Simulation models and decision trees enhance management’s initial

capital budget decision efforts and also expedite intermediate decisions (whether

to continue, revise, or even cancel investment plans) once the initial decision has

been made.

B. Simulation models – various values for economic and financial variables affecting

the capital budgeting decision are randomly selected and used as inputs in the

simulation model. Although the process does not ensure that a manager’s decision

will be correct (in terms of actual events), decisions can be made with a greater

understanding of possible outcomes.

PPT Simulation Flow Chart (Figure 13-7)

C. Decision trees – the sequential pattern of decisions and resulting outcomes and

associated probabilities (managerial estimates based on experience and statistical

processes) are tracked along the branches of the decision tree. Tracing the

sequence of possible events in this fashion is a valuable analytical tool in the

decision making process.

PPT Decision Trees (Table 13-8)

V. The Portfolio Effect

A. A risky project may actually reduce the total risk of the firm through the portfolio

effect.

B. Projects that move in opposite directions in response to the same economic

stimulus are negatively correlated. Since the movement of negatively correlated

projects is in opposite directions, the total deviation is less than the deviations of

the projects individually.

C. The relationship between project movements is expressed by the coefficient of

correlation that varies from the extremes of -1 (perfectly negative) to +1

(perfectly positive) correlation. Non-correlated projects have a correlation

coefficient of zero.

D. Although projects with correlation coefficients of -1 are seldom found, some risk

reduction will occur, however minor, when projects are negatively correlated or

have low positive correlation.

PPT Rates of return for Conglomerate, Inc., and two merger candidates

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(Table 13-8)

Perspective 13-5: Table 13-8 is a good example of how negatively correlated projects can

reduce risk when combined.

E. The firm should strive to achieve two objectives in combining projects according

to their risk-return characteristics.

1. Achieve the highest possible return at a given risk level.

2. Allow the lowest possible risk at a given return level.

F. The various optimal combinations of projects are located along a risk-return line

referred to as the “efficient frontier.”

PPT Risk-Return Trade-Offs (Figure 13-10)

Finance in Action: Real Options Add a New Dimension to Capital Budgeting

This article discusses real options not considered under traditional capital budgeting decisions.

These real options include intermittent decision points throughout the project. These decision

points provide the opportunity for the firm to continue or revise project plans or abandon the

project altogether. This sophisticated technique is not widely used but is expected to increase in

the future.

VI. The Share Price Effect

A. Higher earnings do not necessarily contribute to the firm’s goal of owner’s wealth

maximization. The firm’s earnings may be discounted at a higher rate because

investors perceive that the firm is pursuing riskier projects to generate the

earnings.

B. The risk aversion of investors is verified in the capital market. Firms that are very

sensitive to cyclical fluctuations tend to sell at lower P/E multiples.

Other Chapter Supplements

Cases for Use with Foundations of Financial Management

Case 20, Global Resources. (Risk-Adjusted Discount Rates)

Case 21, Inca, Inc. (Capital Budgeting with Risk)

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