Lecture 9

Risk and Refinements in Capital Budgeting

 Introduction to Risk in Capital
Budgeting
• Thus far, we have assumed that all investment
projects have the same level of risk as the firm.
• In other words, we assumed that all projects are
equally risky, and the acceptance of any project
would not change the firm’s overall risk.
• In actuality, these situations are rare—projects are not
equally risky, and the acceptance of a project can
affect the firm’s overall risk.

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Table 12.1 Cash Flows and NPVs for
Bennett Company’s Projects

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Behavioral Approaches for Dealing with
Risk: Risk and Cash Inflows
• Behavioral approaches can be used to get a “feel” for the level
of project risk, whereas other approaches try to quantify and
measure project risk.

• Risk (in capital budgeting) refers to the uncertainty

surrounding the cash flows that a project will generate or,
more formally, the degree of variability of cash flows.

• In many projects, risk stems almost entirely from the cash

flows that a project will generate several years in the future,
because the initial investment is generally known with relative
certainty.

• To assess the risk of a proposed capital expenditure the analyst

needs to determine whether the cash inflows will be large
enough to produce a positive NPV.
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Behavioral Approaches for Dealing with Risk:
Risk and Cash Inflows (cont.)

Treadwell Tire Company, a tire retailer with a 10% cost

of capital, is considering investing in either of two
mutually exclusive projects, A and B. Each requires a
$10,000 initial investment, and both are expected to
provide constant annual cash inflows over their 15-year
lives. For either project to be acceptable its NPV must
be greater than zero.

© 2012 Pearson Prentice Hall. All rights

reserved. 12-5
Behavioral Approaches for Dealing with Risk: Risk and Cash
Inflows (cont.)

This is the breakeven cash inflow, that will result in an NPV = 0.

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Behavioral Approaches for Dealing with
Risk: Scenario Analysis
• Scenario analysis is a behavioral approach that uses
several possible alternative outcomes (scenarios), to
obtain a sense of the variability of returns, measured
here by NPV.
• In capital budgeting, one of the most common
scenario approaches is to estimate the NPVs
associated with pessimistic (worst), most likely
(expected), and optimistic (best) estimates of cash
inflow.
• The range can be determined by subtracting the
pessimistic-outcome NPV from the optimistic-
outcome NPV.

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Table 12.2 Scenario Analysis of
Treadwell’s Projects A and B

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 Behavioral Approaches for Dealing
with Risk: Simulation
Simulation is a statistics-based behavioral approach
that applies predetermined probability distributions and
random numbers to estimate risky outcomes.

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Figure 12.1 NPV Simulation

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 Risk-Adjusted Discount Rates
Risk-adjusted discount rates (RADR) are rates of
return that must be earned on a given project to
compensate the firm’s owners adequately—that is, to
maintain or improve the firm’s share price.

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 Example
Talor Namtig is considering investing $1,000 in either
of two stocks—A or B. She plans to hold the stock for
exactly 5 years and expects both stocks to pay $80 in
annual end-of-year cash dividends. At the end of the
year 5 she estimates that stock A can be sold to net
$1,200 and stock B can be sold to net $1,500. Her
research indicates that she should earn an annual return
on an average risk stock of 11%. Because stock B is
considerably riskier, she will require a 14% return from
it. Talor makes the following calculations to find the
risk-adjusted net present values (NPVs) for the two
stocks:

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 Personal Finance Example (cont.)

Although Talor’s calculations indicate that both stock

investments are acceptable (NPVs > $0), on a risk-adjusted
basis, she should invest in Stock B because it has a higher
NPV.
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 Risk-Adjusted Discount Rates:
Review of CAPM
Using beta, bj, to measure the relevant risk of any asset j, the
CAPM is
rj = RF + [bj  (rm – RF)]
where
rj = required return on asset j
RF = risk-free rate of return
bj = beta coefficient for asset j
rm = return on the market portfolio of assets

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 Figure 12.2
CAPM and SML

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 Risk-Adjusted Discount Rates:
Using CAPM to Find RADRs (cont.)
Figure 12.2 shows two projects, L and R.
• Project L has a beta, bL, and generates an internal rate of
return, IRRL. The required return for a project with risk bL is
r L.
– Because project L generates a return greater than that required (IRRL >
rL), project L is acceptable.
– Project L will have a positive NPV when its cash inflows are
discounted at its required return, rL.
• Project R, on the other hand, generates an IRR below that
required for its risk, bR (IRRR < rR).
– This project will have a negative NPV when its cash inflows are
discounted at its required return, rR.
– Project R should be rejected.

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 Risk-Adjusted Discount Rates:
Applying RADRs
Bennett Company wishes to apply the Risk-Adjusted
Discount Rate (RADR) approach to determine whether
to implement Project A or B. In addition to the data
presented earlier, Bennett’s management assigned a
“risk index” of 1.6 to project A and 1.0 to project B as
indicated in the following table. The required rates of
return associated with these indexes are then applied as
the discount rates to the two projects to determine NPV.

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Risk-Adjusted Discount Rates:
Applying RADRs (cont.)

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Figure 12.3a Calculation of NPVs for Bennett Company’s
Capital Expenditure Alternatives Using RADRs

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Figure 12.3b Calculation of NPVs for Bennett Company’s
Capital Expenditure Alternatives Using RADRs

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Risk-Adjusted Discount Rates:
Applying RADRs (cont.)
Project A Project B

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 Risk-Adjusted Discount Rates:
Portfolio Effects
• As noted earlier, individual investors must hold
diversified portfolios because they are not rewarded
for assuming diversifiable risk.
• Because business firms can be viewed as portfolios of
assets, it would seem that it is also important that they
too hold diversified portfolios.
• Surprisingly, however, empirical evidence suggests
that firm value is not affected by diversification.
• In other words, diversification is not normally
rewarded and therefore is generally not necessary.

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 Risk-Adjusted Discount Rates:
Portfolio Effects (cont.)
• It turns out that firms are not rewarded for
diversification because investors can do so
themselves.
• An investor can diversify more readily, easily, and
costlessly simply by holding portfolios of stocks.

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Table 12.3 Bennett Company’s
Risk Classes and RADRs

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 Risk-Adjusted Discount Rates:
RADRs in Practice (cont.)
Assume that the management of Bennett Company decided to use
risk classes to analyze projects and so placed each project in one
of four risk classes according to its perceived risk. The classes
ranged from I for the lowest-risk projects to IV for the highest-
risk projects.

The financial manager of Bennett has assigned project A to class

III and project B to class II. The cash flows for project A would
be evaluated using a 14% RADR, and project B’s would be
evaluated using a 10% RADR. The NPV of project A at 14% was
calculated in Figure 12.3 to be $6,063, and the NPV for project B
at a 10% RADR was shown in Table 12.1 to be $10,924.

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 Capital Budgeting Refinements:
Comparing Projects With Unequal Lives
• The financial manager must often select the best of a
group of unequal-lived projects.
• If the projects are independent, the length of the
project lives is not critical.
• But when unequal-lived projects are mutually
exclusive, the impact of differing lives must be
considered because the projects do not provide
service over comparable time periods.

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Capital Budgeting Refinements: Comparing Projects With
Unequal Lives (cont.)

The AT Company, a regional cable-TV firm, is

evaluating two projects, X and Y. The projects’ cash
flows and resulting NPVs at a cost of capital of 10% is
given below.

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Capital Budgeting Refinements: Comparing Projects With
Unequal Lives (cont.)

Project X Project Y

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 Capital Budgeting Refinements:
Comparing Projects With Unequal Lives
Ignoring the difference in their useful lives, both
projects are acceptable (have positive NPVs).
Furthermore, if the projects were mutually exclusive,
project Y would be preferred over project X. However,
it is important to recognize that at the end of its 3 year
life, project Y must be replaced, or renewed.

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 Capital Budgeting Refinements:
Comparing Projects With Unequal Lives
The annualized net present value (ANPV) approach is an
approach to evaluating unequal-lived projects that converts the
net present value of unequal-lived, mutually exclusive projects
into an equivalent annual amount (in NPV terms).
Step 1 Calculate the net present value of each project j,
NPVj, over its life, nj, using the appropriate cost of
capital, r.
Step 2 Convert the NPVj into an annuity having life nj.
That is, find an annuity that has the same life and
the same NPV as the project.
Step 3 Select the project that has the highest ANPV.

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Capital Budgeting Refinements: Comparing Projects With
Unequal Lives (cont.)

By using the AT Company data presented earlier for

projects X and Y, we can apply the three-step ANPV
approach as follows:
Step 1 The net present values of projects X and Y
discounted at 10%—as calculated in the
preceding example for a single purchase of
each asset—are
NPVX = $11,277.24 (table value = $11,248)
NPVY = $19,013.27 (table value = $18,985)

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Capital Budgeting Refinements: Comparing Projects With
Unequal Lives (cont.)

Step 2 In this step, we want to convert the NPVs

from Step 1 into annuities. For project X,
we are trying to find the answer to the
question, what 3-year annuity (equal to the
life of project X) has a present value of
$11,248 (the NPV of project X)? Likewise,
for project Y we want to know what 6-year
annuity has a present value of $18,985.
Once we have these values, we can
determine which project, X or Y, delivers a
higher annual cash flow on a present value
basis.

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Capital Budgeting Refinements: Comparing Projects With
Unequal Lives (cont.)

Project X Project Y

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Capital Budgeting Refinements: Comparing Projects With
Unequal Lives (cont.)

Step 3 Reviewing the ANPVs calculated in Step 2,

we can see that project X would be
preferred over project Y. Given that projects
X and Y are mutually exclusive, project X
would be the recommended project because
it provides the higher annualized net present
value.

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 Recognizing Real Options
Real options are 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.
By explicitly recognizing these options when making
capital budgeting decisions, managers can make
improved, more strategic decisions that consider in
advance the economic impact of certain contingent
actions on project cash flow and risk.
NPVstrategic = NPVtraditional + Value of real options

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 Table 12.4
Major Types of Real Options

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 Recognizing Real Options (cont.)
Assume that a strategic analysis of Bennett Company’s
projects A and B finds no real options embedded in
Project A but two real options embedded in B:
1. During it’s first two years, B would have downtime that
results in unused production capacity that could be used to
perform contract manufacturing;
2. Project B’s computerized control system could control
two other machines, thereby reducing labor costs.

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 Recognizing Real Options (cont.)
Bennett’s management estimated the NPV of the contract
manufacturing over the two years following implementation of
project B to be $1,500 and the NPV of the computer control
sharing to be $2,000. Management felt there was a 60% chance
that the contract manufacturing option would be exercised and
only a 30% chance that the computer control sharing option
would be exercised. The combined value of these two real
options would be the sum of their expected values.
Value of real options for project B
= (0.60  $1,500) + (0.30  $2,000)
= $900 + $600 = $1,500

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 Recognizing Real Options (cont.)
Adding the $1,500 real options value to the traditional NPV of
$10,924 for project B, we get the strategic NPV for project B.
NPVstrategic = $10,924 + $1,500 = $12,424
Bennett Company’s project B therefore has a strategic NPV of
$12,424, which is above its traditional NPV and now exceeds
project A’s NPV of $11,071. Clearly, recognition of project B’s
real options improved its NPV (from $10,924 to $12,424) and
causes it to be preferred over project A (NPV of $12,424 for B >
NPV of $11,071 for A), which has no real options embedded in it.

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 Capital Rationing
• Firm’s often operate under conditions of capital
rationing—they have more acceptable independent
projects than they can fund.
• In theory, capital rationing should not exist—firms
should accept all projects that have positive NPVs.
• However, in practice, most firms operate under
capital rationing.
• Generally, firms attempt to isolate and select the best
acceptable projects subject to a capital expenditure
budget set by management.

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 Capital Rationing (cont.)
• The internal rate of return approach is an approach
to capital rationing that involves graphing project
IRRs in descending order against the total dollar
investment to determine the group of acceptable
projects.
• The graph that plots project IRRs in descending order
against the total dollar investment is called the
investment opportunities schedule (IOS).
• The problem with this technique is that it does not
guarantee the maximum dollar return to the firm.

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 Capital Rationing (cont.)
Tate Company, a fast growing plastics company with a
cost of capital of 10%, is confronted with six projects
competing for its fixed budget of $250,000.

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Figure 12.4 Investment
Opportunities Schedule

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 Capital Rationing (cont.)
• The net present value approach is an approach to
capital rationing that is based on the use of present
values to determine the group of projects that will
maximize owners’ wealth.
• It is implemented by ranking projects on the basis of
IRRs and then evaluating the present value of the
benefits from each potential project to determine the
combination of projects with the highest overall
present value.

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 Table 12.5 Rankings for Tate
Company Projects

Projects B, C and E have a total NPV of $106,000

($336,000 - $230,000). Projects B, C and A is preferable as
it has an NPV of $107,000 ($357,000 - $250,000) without
going over the budget. 12-45