This document discusses two methods for evaluating risky projects: the risk-adjusted discount rate method and the certainty equivalent method. The risk-adjusted discount rate method forecasts expected cash flows and discounts them using a risk-adjusted discount rate. The certainty equivalent method forecasts risk-adjusted cash flows by finding their certainty equivalent value, and discounts them using the risk-free rate. Both methods use the CAPM or APT to determine project risk, but the certainty equivalent method does so by finding the cash flow beta rather than the return beta.
This document discusses two methods for evaluating risky projects: the risk-adjusted discount rate method and the certainty equivalent method. The risk-adjusted discount rate method forecasts expected cash flows and discounts them using a risk-adjusted discount rate. The certainty equivalent method forecasts risk-adjusted cash flows by finding their certainty equivalent value, and discounts them using the risk-free rate. Both methods use the CAPM or APT to determine project risk, but the certainty equivalent method does so by finding the cash flow beta rather than the return beta.
This document discusses two methods for evaluating risky projects: the risk-adjusted discount rate method and the certainty equivalent method. The risk-adjusted discount rate method forecasts expected cash flows and discounts them using a risk-adjusted discount rate. The certainty equivalent method forecasts risk-adjusted cash flows by finding their certainty equivalent value, and discounts them using the risk-free rate. Both methods use the CAPM or APT to determine project risk, but the certainty equivalent method does so by finding the cash flow beta rather than the return beta.
This document discusses two methods for evaluating risky projects: the risk-adjusted discount rate method and the certainty equivalent method. The risk-adjusted discount rate method forecasts expected cash flows and discounts them using a risk-adjusted discount rate. The certainty equivalent method forecasts risk-adjusted cash flows by finding their certainty equivalent value, and discounts them using the risk-free rate. Both methods use the CAPM or APT to determine project risk, but the certainty equivalent method does so by finding the cash flow beta rather than the return beta.
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Risky Projects
Knut P. Heen PhD
Associate Professor Molde University College Road Map Based on HGT chapter 11 The Risk-Adjusted Discount Rate Method Tracking Portfolio and Tracking Error From Tracking to Discounting Comparable Investments and Leverage Potential Pitfalls The Certainty Equivalent Method Essentially a Two-Step Procedure of the Above
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Two Methods The risk-adjusted discount rate method (standard) Forecast expected cash flows Discount with risk-adjusted discount rate
Certainty equivalent method (alternative)
Forecast risk-adjusted cash flows Discount with the risk-free rate
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The Risk-Adjusted Discount Rate Method Tracking portfolio approach Find portfolio which tracks project cash flows (CAPM or APT) Present value of cash flows = value of tracking portfolio
Tracking error Risky projects → tracking error (imperfect tracking) Problem if tracking error contains systematic risk
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Hilton Hotels Example (p. 351)
Cash Flows State Probability Hilton Hotels Market Portfolio Good 0.4 12,3 mill 1,4 Average 0.4 11,3 mill 1,2 Bad 0.2 9,3 mill 0,8
Risk-free rate 0,06
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Hilton Hotels Example cont’d Tracking portfolio $5 million in risk-free → $5.3 million
$5 million in market portfolio
Present value of project is $10 million 50 percent in risk-free 50 percent in market portfolio
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Tracking Error Example
Cash Flows State Probability Hilton Hotels Market Portfolio Good 0.4 12,4 mill 1,4 Average 0.4 11,2 mill 1,2 Bad 0.2 9,3 mill 0,8
Risk-free rate 0,06
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Tracking Error Example cont’d Tracking portfolio As before (50/50 risk-free/market)
Tracking error State Probability Project Portfolio Error Good 0,4 $12,4 $12,3 -$0,1 Average 0,4 $11,2 $11,3 +$0,1 Bad 0,2 $9,3 $9,3 $0
Expected error
Not a problem if expected error is unsystematic
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From Tracking to Discounting Hilton CAPM tracking portfolio CAPM portfolio consist of Weight 1-β in risk-free asset (50 percent) Weight β in the market portfolio (50 percent) Hilton project β is therefore 0.5 Market return: Cash flow: Discounted cash flow
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Present Value of Future Risky CFs Risk-Adjusted Discount Rate Method Find expected cash flow, E(CF) Find project beta, β(s) (tracking portfolio) Find expected return on tracking portfolio Discount E(CF) with return on tracking portfolio
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How to Find Project Beta? Usually through “comparable” investments A new project is obviously not traded in the market already Comparable real projects are usually not traded either Securities of firms owning comparable projects are, however, traded Use these to estimate project beta (industry/sector beta) We will come back to some pitfalls later
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The Effect of Leverage Balance sheet Real Assets, A Debt, D Equity, E
Accounting identity Value of equity & debt must equal value of assets
Risk-free debt Implies that all risk is borne by equityholders
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Equity Beta Volatility of equity
Beta
Note that risky debt has
Expected return
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Expected Return & Leverage r
rE
rA
rD
D/E
pdefault = 0 pdefault > 0
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Implementation Don’t forget Comparable firms should have comparable assets But comparable firms may have different leverage
Implication Must de-lever βE/rE of comparable firms (find rA)
Weighting of comparable firms
Often good idea to use a value-weighted β Be careful with observations of highly levered firms
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Potential Pitfalls Project beta vs. firm beta Not necessarily identical (fixed costs → operating leverage) Growth opportunities Options are levered-equity → growth options have high betas
Firm beta will be an average beta of AIP and GO
Multi-period discounting Using the same discount rate for every cash flow Long-term rf or short-term rf? Time-varying beta?
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CAPM vs. APT Largely a matter of belief (at this point) All the same mathematical rules apply to APT as well
You will, of course, come up with different PVs/NPVs with the two methods
Problem with APT
People may choose factors to produce high PVs Not as easy to misuse the CAPM (you are married to the market portfolio)
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The Certainty Equivalent Method Approach Risk-adjust cash flows directly → certainty equivalent, CE Discount the certainty equivalent cash flow with risk-free rate
How to compute CE?
Find cash flow beta (amount invested in tangent portfolio)
Compute CE(CF) and PV(CF)
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The Hilton Example Recall Expected cash flow was $11.3 million Amount invested in the market portfolio was $5 million Certainty equivalent: Present value:
Conclusion A two-step procedure which is equivalent with risk-adjusted discount rate method
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When is the CE-Method Useful? Some situations When it is more convenient to obtain the cash flow beta (b) than the return beta (β) When finding “comparable” investments is difficult Convenient in scenario-analysis (the Hilton example) When forward prices are available Forward prices are certainty equivalents
