Risk in Capital Budgeting

All of the projects' relevant cash flows were assumed to have the same level of risk as the firm. All
mutually exclusive projects were equally risky, and the acceptance of any project would not change the
firm's overall risk. In actuality, these situations are rare-project cash flows typically have different levels
of risk, and the acceptance of a project generally does affect the firm's overall risk, though
often in a minor way.

QUESTION 10-1 Are most mutually exclusive capital budgeting projects equally risky? How can the
acceptance of a project change a firm's overall risk?

TABLE 10.1 Relevant Cash Flows and NPVS for Bennett Company's Projects

Project A Project B
A.Relevant cash flows
Initial investment $42,000 $45,000
Year Operating cash inflows
1 $14,000 $28,000
2 14,000 12,000
3 14,000 10,000
4 14,000 10,000
5 14,000 10,000
B.Decision technique
NPV @10% cost of capital $11,071 $10,924

Risk and Cash Inflows

The term risk refers to the chance that a project will prove unacceptable-that is, NPV<$0 or IRR <cost of
capital. More formally, risk in capital budgeting is the degree of variability of cash flows. Projects with a
small chance of acceptability and a broad range of expected cash flows are more risky than projects that
have a high chance of acceptability and a narrow range of expected cash flows.

Capital budgeting projects assumed risk stems almost entirely from cash inflows, because the initial
investment is generally known with relative certainty. These inflows derive from a number of variables
related to revenues, expenditures, and taxes. We will concentrate on the risk in the cash inflows. The
analyst needs to evaluate the probability that the cash inflows will be large enough to provide for project
acceptance.

Example

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 equal annual cash inflows over their 15-year lives. For either project to be acceptable according
to the net present value technique, its NPV must be greater than zero. If we let CF equal the annual cash
inflow and let CF0 equal the initial investment, the following condition must be met for projects with
annuity cash inflows, such as A and B, to be acceptable.

NPV= [CFX (PVIFAr,n)]-CFo>$0 ……… (10.1)

By substituting r=10%, n=15 years, and CF0 = $10,000, we can find the = breakeven cash inflow-the
minimum level of cash inflow necessary for Tread- well's projects to be acceptable.
Table Use The present value interest factor for an ordinary annuity at 10% for 15 years (PVIFA10%,15yrs)
found in Table A-4 is 7.606. Substituting this value and the initial investment (CF0) of $10,000 into
Equation 10.1 and solving for the breakeven cash inflow (CF), we get

[CFX (PVIFA10%,15yrs)]-$10,000>$0

CFX (7.606)>$10,000
$10,000
CF> 7.606
=$1,314.75

Table values indicate that for the projects to be acceptable, they must have annual cash inflows of at
least $1,315. The risk of each project could be assessed by determining the probability that the project's
cash inflows will equal or exceed this breakeven level. For now, we can simply assume that such a
statistical analysis results in the following:

Probability of CFA >$1,315 ….. 100%

Probability of CFB >$1,315 ….. 65%

Because project A is certain (100% probability) to have a positive net present value, whereas there is only
a 65% chance that project B will have a positive NPV project A is less risky than project B.

The example clearly identifies risk as it is related to the chance that a project is acceptable, but it does
not address the issue of cash flow variability. Even though project B has a greater chance of loss than
project A. It is the combination of risk and return. The worth of a capital expenditure and its impact on
the firm's value must be viewed in light of both risk and return. Consider the variability of cash inflows
and NPVs to assess project risk and return fully.

Scenario Analysis

Scenario analysis can be used to deal with project risk to capture the variability of cash inflows and NPVs.
Scenario analysis is a behavioral approach that uses several possible alternative outcomes (scenarios),
such as cash inflows, to obtain a sense of the variability among 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.

TABLE 10.2 Scenario Analysis of Treadwell’s Project A and B

Project A Project B
Initial investment $10,000 $10,000
Annual cash inflows
Outcome
Pessimistic $1,500 $ 0
Most likely 2,000 2,000
Optimistic 2,500 4,000
Range $1,000 $4,000
Net present values
Outcome
Pessimistic $1,409 -$10,000
Most likely 5,212 5,212
Optimistic 9,015 20,424
Range $7,606 $30,424

These values were calculated by using the corresponding annual cash inflows. A 10% cost of capital and a
15-year life for the annual cash inflows were used.
The cash inflow outcomes and resulting NPVs in each case are summarized in Table 10.2. Comparing the
ranges of cash inflows ($1.000 for project A and $4,000 for B) and, more important, the ranges of NPVs
($7,606 for project A and $30,424 for B) makes it clear that project A is less risky than project B. Given
that both projects have the same most likely NPV of $5.212. the assumed risk-averse decision maker will
take project A because it has less risk (smaller NPV range) and no possibility of loss (all NPVs>$0).

International Risk Considerations

Although the basic techniques of capital budgeting are the same for multinational companies (MNCs) as
for purely domestic firms, firms that operate in several countries face risks that are unique to the
international arena. Two types of risk are particularly important: exchange rate risk and political risk.

Exchange rate risk reflects the danger that an unexpected change in the exchange rate between the
dollar and the currency in which a project's cash flows are denominated will reduce the market value of
that project's cash flow. In the short term, specific cash flows can be hedged by using financial
instruments such as currency futures and options. Long-term exchange rate risk can best be minimized by
financing the project, in whole or in part, in local currency.

Political risk is much harder to protect against. Once a foreign project is accepted, the foreign
government can block the return of profits, seize the firm's assets, or otherwise interfere with a project's
operation. Managers account for political risks before making an investment. They can do so either by
adjusting a project's expected cash inflows to account for the probability of political interference or by
using risk-adjusted discount rates in capital budgeting formulas. In general, it is much better to adjust
individual project cash flows for political risk subjectively than to use a blanket adjustment
for all projects.

In addition to unique risks that MNCs must face, several other special issues are relevant only for
international capital budgeting.

Another special issue in international capital budgeting is transfer pricing. Much of the international trade
involving MNCs is, in reality, simply the shipment of goods and services from one of a parent company's
subsidiaries to another subsidiary located abroad. The parent company therefore has great discretion in
setting transfer prices, the prices that subsidiaries charge each other for the goods and services traded
between them. The widespread use of transfer pricing in international trade makes capital budgeting in
MNCs very difficult unless the transfer prices that are used accurately reflect actual costs and incremental
cash flows.

Finally, MNCs often must approach international capital projects from a strategic point of view, rather
than from a strictly financial perspective. For example, an MNC may feel compelled to invest in a country
to ensure continued access, even if the project itself may not have a positive net present value.

Risk-Adjusted Discount Rates

We will now illustrate the most popular risk- adjustment technique that employs the net present value
(NPV) decision method. The NPV decision rule of accepting only those projects with NPVS>$0 will
continue to hold. The initial investment (CF0) is known with certainty, a project's risk is embodied in the
present value of its cash inflows:
𝑛
𝐶𝐹𝑡
∑
(1 + 𝑟)𝑡
𝑡=1

Two opportunities to adjust the present value of cash inflows for risk exist:

(1) The cash inflows (CFt) can be adjusted, or

(2) The discount rate (r) can be adjusted.

Determining Risk-Adjusted Discount Rates (RADRS)

Employs a risk-adjusted dis- count rate, as noted in the following expression:

𝐶𝐹𝑡
𝑁𝑃𝑉 = ∑𝑛𝑡=1 (1+𝑅𝐴𝐷𝑅)𝑡 − 𝐶𝐹0 ≥ 0 ……… (10.2)

The risk-adjusted discount rate (RADR) is the rate 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. The
higher the risk of a project, the higher the RADR, and therefore the lower the net present value for a
given stream of cash inflows.

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 esti- mates that stock A can be sold to net $1,200 and stock B can be sold to net
$1.500. Talor has carefully researched the two stocks and feels that although stock A has average risk,
stock B is considerably riskier. 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:

NPVA = [$80 x (PVIFA11%,5yrs)]+[$1,200 x (PVIF11%,5yrs)]-$1,000

Using a financial calculator, she gets:

NPVA = $1,007.81 - $1,000 = $7.81

NPVB = [$80 x (PVIFA14%,5yrs)]+[$1,500 x (PVIF14%,5yrs)]-$1,000

Using a financial calculator, she gets:

NPVB = $1,053.70 - $1,000 = $53.70

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. Because the logic underliving the
use of RADRs is closely linked to the capital asset pricing model (CAPM).

Review of CAPM
The capital asset pricing model (CAPM) to link the relevant risk and return for all assets traded in efficient
markets. In the development of the CAPM, the total risk of an asset was defined as

Total risk = Nondiversifiable risk + Diversifiable risk ………. (10.3)

For assets traded in an efficient market, the diversifiable risk, which results from uncontrollable or
random events, can be eliminated through diversification. The relevant risk is therefore the
nondiversifiable risk -the risk for which owners of these assets are rewarded. Nondiversifiable risk for
securities is commonly measured by using beta, which is an index of the degree of movement of an
asset's return in response to a change in the market return.

Using beta, bj, to measure the relevant risk of any asset j, the CAPM is

Rj = RF + [bj x (rm - RF)] …….. (10.4) 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

We demonstrated that the required return on any asset could be determined by substituting values of RF,
bj, and rm into the CAPM -Equation 10.4. Any security that is expected to earn in excess of its required
return would be acceptable, and those that are expected to earn an inferior return would be rejected.
Using CAPM to Find RADRS
The CAPM can be redefined as noted in Equation 10.5:

rproject j = RF + [bproject j X (rm -RF)] ……….. (10.5)

The security market line (SML)-the graphical depiction of the CAPM-is shown for Equation 10.5 in Figure
10.2. Any project having an IRR above the SML would be acceptable, because its IRR would exceed the
required return rproject j any project with an IRR below rproject would be rejected. In terms of NPV, any
project falling above the SML would have a positive NPV, and any project falling below the SML would
have a negative NPV.

Figure 10.2 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 rL. 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.

Applying RADRS
Because the CAPM is based on an assumed efficient market, which does not exist for real corporate
(nonfinancial) assets such as plant and equipment, the CAPM is got directly applicable in making capital
budgeting decisions. Financial managers therefore assess the total risk of a project and use it to
determine the risk-adjusted discount rate (RADR), which can be used in Equation 10.2 to find the NPV.

To avoid damaging its market value, the firm must use the correct discount rate to evaluate a project. If a
firm fails to incorporate all relevant risks in its decision-making process, it may discount a risky project's
cash inflows at too low a rate and accept the project. The firm's market price may drop later as investors
recognize that the firm itself has become more risky. Conversely, if the firm discounts a project's cash
inflows at too high a rate, it will reject acceptable projects, Eventually the firm's market price may drop,
because investors who believe that the firm is being overly conservative will sell their stock, putting
downward pressure on the firm's market value.

Unfortunately, there is no formal mechanism for linking total project risk.to the level of required return.
As a result, most firms subjectively determine the RADR by adjusting their existing required return. They
adjust it up or down depending on whether the proposed project is more or less risky, respectively, than
the average risk of the firm. This CAPM-type of approach provides a "rough estimate" of the project risk
and required return.
Example
Bennett Company wishes to use the risk-adjusted discount rate approach to determine, according to
NPV, whether to implement project A or project B. In addition to the data presented in part A of Table
10.1, Bennett's management after much analysis subjectively assigned "risk indexes" of 1.6 to project A
and 1.0 to project B. The risk index is merely a numerical scale used to classify project risk: Higher index
values are assigned to higher-risk projects, and vice versa. The CAPM-type relationship used by the firm
to link risk (measured by the risk index) and the required return (RADR) is shown in the following table.

Risk index Required return (RADR)

0.0 6
0.2 7
0.4 8
0.6 9
0.8 10
Project B 1.0 11
1.2 12
1.4 13
Project A 1.6 14
1.8 16
2.0 18

Because project A is riskier than project B, its RADR of 14% is greater than project B's 11%. The results
clearly show that project B is preferable, because its risk-adjusted NPV of $9.798 is greater than the
$6,063 risk-adjusted NPV for project A. As reflected by the NPVs in part B of Table 10.1. if the discount
rates were not adjusted for risk, project A would be preferred to project B.

The usefulness of risk-adjusted discount rates should now be clear. The real difficulty lies in estimating
project risk and linking it to the required return (RADR).
RADRS in Practice
In spite of the appeal of total risk, RADRs are often used in practice. Their popularity stems from two
facts: (1) They are consistent with the general disposition of financial decision makers toward rates of
return, and (2) they are easily esti mated and applied. The first reason is clearly a matter of personal
preference, but the second is based on the computational convenience and well-developed procedures
involved in the use of RADRs.

In practice, firms often establish a number of risk classes, with an RADR assigned to each. Like the CAPM-
type risk-return relationship described earlier, management develops the risk classes and RADRs based
on both CAPM and the risk-return behaviors of past projects. Each new project is then subjectively placed
in the appropriate risk class, and the corresponding RADR is used to evaluate it.

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.

TABLE 10.3 Bennett Company's Risk Classes and RADRs

Risk-adjusted
discount rate
Risk class Description RADR
I Below-average risk: Projects with low risk. Typically involve routine 8%
replacement without renewal of existing activities.
II Average risk: Projects similar to those currently implemented. Typically 10%
involve replacement or renewal of existing activities.
lll Above-average risk: Projects with higher than normal, but not excessive, 14%
risk. Typically involve expansion of existing or similar activities.
IV Highest risk: Projects with very high risk. Typically involve expansion into 20%
new or unfamiliar activities.

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 10.3 to be $6,063, and the NPV for
project B at a 10% RADR was shown in Table 10.1 to be $10,924. Clearly, with RADRS based on the use of
risk classes, project B is preferred over project A. As noted earlier, this result is contrary to the
preferences shown in Table 10.1, where differing risks of projects A and B were not taken into account.

REVIEW QUESTIONS

Question 10-5 Describe the basic procedures involved in using risk-adjusted discount rates (RADRs). How
is this approach related to the capital asset pricing model (CAPM)?

Question 10-7 How are risk classes often used to apply RADRS?
Capital Budgeting Refinements
Refinements must often be made in the analysis of capital budgeting projects to accommodate
special circumstances. Three areas in which special forms of analysis are frequently needed are
(i) comparison of mutually exclusive projects having unequal lives,
(ii) recognition of real options, and
(iii) capital rationing caused by a binding budget constraint.
Comparing Projects with Unequal Lives
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.
Problem
A simple example will demonstrate the basic problem of noncomparability caused by the need
to select the best of a group of mutually exclusive projects with differing usable lives.
The AT Company, a regional cable television company, is evaluating two projects, X and Y. The
relevant cash flows for each project are given in the following table. The applicable cost of
capital for use in evaluating these equally risky projects is 10%.
Project X Project Y
Initial investment $70,000 $85,000
Year Annual cash inflows
1 $28,000 $35,000
2 33,000 30,000
3 38,000 25,000
4 -- 20,000
5 -- 15,000
6 -- 10,000

Calculator Use Employing the preprogrammed NPV function in a financial calculator, we use
the keystrokes shown at the left for project X and for project Y to find their respective NPVs of
$11,277.24 and $19,013.27
Table Use The net present value of each project at the 10% cost of capital is calculated by
finding the present value of each cash inflow, summing these values, and subtracting the initial
investment from the sum of the present values.

NPVx = [$28,000 x (0.909)] + [$33,000 x (0.826)] + [$38,000 x (0.751)] - $70,000

= ($25,452 + $27,258 + $28,538) - $70,000
= $81,248 - $70,000
= $11,248

NPVY = [$35,000 X (0.909)] + [$30,000 X (0.826)] + [$25,000 X (0.751)]+[$20,000 x (0.683)] +

[$15,000 x (0.621)] + [$10,000 x (0.564)] - $85,000
= ($31,815 + $24,780 + $18,775 + $13,660 + $9,315 + $5,640) - $85,000
= $103,985 - $85,000
= $18,985

The NPV for project X is $11,248; that for project Y is $18,985.

Ignoring the difference in project lives, we can see that both projects are acceptable (both NPVs
are greater than zero) and that project Y is preferred over project X. If the projects were
independent and only one could be accepted, project Y with the larger NPV would be preferred.
If the projects were mutually exclusive, their differing live would have to be considered. Project Y
provides 3 more years of service than project X.
The analysis in the above example is incomplete if the projects are mutually exclusive. To compare these
unequal-lived, mutually exclusive projects correctly, we must consider the differing lives in the analysis;
an incorrect decision could result from simply using NPV to select the better project. Although a number
of approaches are available for dealing with unequal lives, here we present the most efficient technique
the annualized net present value (ANPV) approach.

Annualized Net Present Value (ANPV) Approach

The annualized net present value (ANPV) approach converts the net present value of unequal-lived,
mutually exclusive projects into an equivalent annual amount (in NPV terms) that can be used to select
the best project. This net present value based approach can be applied to unequal-lived, mutually
exclusive projects by using the following steps:

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 Divide the net present value of each project having a positive NPV by the present value interest
factor for an annuity at the given cost of capital and the project's life to get the annualized net present
value for each project j, ANPVj, as shown below:
𝑁𝑃𝑉𝑗
ANPVj = PVIFAr,nj
… … … (30.5)

Step 3 Select the project that has the highest ANPV.

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)

Step 2 Calculator Use The keystrokes required to find the ANPV on a financial calculator are
identical to those demonstrated in Chapter 4 for finding the annual payments on an installment
loan. These keystrokes are shown at the left for project X and for project Y. The resulting ANPVs
for projects X and Y are $4,534.74 and $4,365.59, respectively.

Table Use Calculate the annualized net present value for each project by applying Equation 10.6
to the NPVs.
$11,248 $11,248
ANPVX = 𝑃𝑉𝐼𝐹𝐴10%,3𝑦𝑟𝑠 = 2,487
= $4,523

$18,985 $18,985
ANPVY = 𝑃𝑉𝐼𝐹𝐴10%,6𝑦𝑟𝑠 = 4,355
= $4,359

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.