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CH 7: Project Analysis Under Risk

Risk in project analysis refers to the variation in predicted future cash flows. There are two main approaches to incorporating risk into project analysis discussed in the chapter: 1) Using a risky discount rate, such as the weighted average cost of capital (WACC) or a rate estimated from the capital asset pricing model (CAPM); and 2) Applying a certainty equivalent factor to adjust the cash flows before discounting them at the risk-free rate. The chapter provides methods and formulas for calculating risky discount rates and certainty equivalent adjustments.

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Priya Kansal
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42 views14 pages

CH 7: Project Analysis Under Risk

Risk in project analysis refers to the variation in predicted future cash flows. There are two main approaches to incorporating risk into project analysis discussed in the chapter: 1) Using a risky discount rate, such as the weighted average cost of capital (WACC) or a rate estimated from the capital asset pricing model (CAPM); and 2) Applying a certainty equivalent factor to adjust the cash flows before discounting them at the risk-free rate. The chapter provides methods and formulas for calculating risky discount rates and certainty equivalent adjustments.

Uploaded by

Priya Kansal
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© Attribution Non-Commercial (BY-NC)
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Ch 7: Project Analysis

Under Risk

Incorporating Risk Into Project Analysis


Through Adjustments To The Discount Rate,
and By The Certainty Equivalent Factor.

1
Introduction: What is Risk?

 Risk is the variation of future expectations


around an expected value.

 Risk is measured as the range of


variation around an expected value.

 Risk and uncertainty are interchangeable


words.
2
Where Does Risk Occur?

 In project analysis, risk is the variation in


predicted future cash flows.
Forecast Estimates of
Varying Cash Flows
End of End of End of End of
Year 0 Year 1 Year 2 Year 3
-$760 ? -$876 ? -$546 ?
-$235 ? -$231 ? -$231 ?
-$1,257 $127 ? $186 ? $190 ?
$489 ? $875 ? $327 ?
$945 ? $984 ? $454 ?
3
Handling Risk

There are several approaches to handling risk:


 In this chapter, risk is accounted for by (1)
applying a discount rate commensurate with the
riskiness of the cash flows, and (2), by using a
certainty equivalent factor
 In chapter 8, risk is accounted for by evaluating the
project using sensitivity and breakeven analysis.
 In chapter 9, risk is accounted for by
evaluating the project under simulated cash
flow and discount rate scenarios. 4
Using a Risky Discount Rate

 The structure of the cash flow discounting


mechanism for risk is:-

 The $ amount used for a ‘risky cash flow’ is the


expected dollar value for that time period.
 A ‘risky rate’ is a discount rate calculated to
include a risk premium. This rate is known as
the RADR, the Risk Adjusted Discount Rate. 5
Defining a
Risky Discount Rate
 Conceptually, a risky discount rate, k, has
three components:-
1. A risk-free rate (r), to account for the time
value of money
2. An average risk premium (u), to account for
the firm’s business risk
3. An additional risk factor (a) , with a positive,
zero, or negative value, to account for the
risk differential between the project’s risk
and the firms’ business risk. 6
Calculating a
Risky Discount Rate
A risky discount rate is conceptually defined as:
k=r+u+a
Unfortunately, k, is not easy to estimate.
Two approaches to this problem are:
1. Use the firm’s overall Weighted Average Cost of
Capital, after tax, as k . The WACC is the overall rate
of return required to satisfy all suppliers of capital.
2. A rate estimating (r + u) is obtained from the
Capital Asset Pricing Model, and then a is added.
7
Calculating the WACC
Assume a firm has a capital structure of:
50% common stock, 10% preferred stock,
40% long term debt.
Rates of return required by the holders of each are :
common, 10%; preferred, 8%; pre-tax debt, 7%.
The firm’s income tax rate is 30%.

WACC = (0.5 x 0.10) + (0.10 x 0.08) +


(0.40 x (0.07x (1-0.30)))
= 7.76% pa, after tax.
8
The Capital Asset Pricing
Model
 This model establishes the covariance
between market returns and returns on a
single security.
 The covariance measure can be used to
establish the risky rate of return, r, for a
particular security, given expected market
returns and the expected risk free rate.

9
Calculating r from the CAPM

 The equation to calculate r, for a security


with a calculated Beta is:

 Where : E  ~
r  is the required rate of
return being calculated, R f is the risk free
rate:  is the Beta of the security, and Rm
is the expected return on the market.
10
Beta is the Slope of an Ordinary
Least Squares Regression Line
Share Returns Regressed On Market
Returns

0.12
0.10
Returns of Share, %

0.08
0.06
0.04
pa

0.02
0.00
-0.10 -0.05 -0.020.00 0.05 0.10 0.15 0.20

-0.04

Returns on Market, % pa 11
The Regression Process
The value of Beta can be estimated as the regression coefficient
of a simple regression model. The regression coefficient ‘a’
represents the intercept on the y-axis, and ‘b’ represents Beta,
the slope of the regression line.
 
  rit  a  bi rmt  u it
Where,  
rit = rate of return on individual firm i’s shares at time t
rmt = rate of return on market portfolio at time t
uit = random error term (as defined in regression
analysis)
12
The Certainty Equivalent Method:
Adjusting the cash flows to their
‘certain’ equivalents
The Certainty Equivalent method adjusts the
cash flows for risk, and then discounts these
‘certain’ cash flows at the risk free rate.
CF1  b CF2  b
NPV   etc  CO
1  r  1
1  r  2

Where: b is the ‘certainty coefficient’ (established


by management, and is between 0 and 1); and r is
the risk free rate. 13
Analysis Under Risk :Summary

 Risk is the variation in future cash flows around a


central expected value.
 Risk can be accounted for by adjusting the NPV
calculation discount rate: there are two methods –
either the WACC, or the CAPM
 Risk can also be accommodated via the Certainty
Equivalent Method.
 All methods require management judgment and
experience.
14

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