ACCT 372 – CHAPTER 13 – RISK AND CAPITAL BUDGETING

WHAT IS RISK ?

 Investment proposals are judged on the basis of return and risk

 Risk means uncertainty about a future outcome
 Investments are risky because future cash flows will likely vary from forecasts
 Risk varies greatly, depending on the investment:
o A T-Bill has zero or no risk
o Nortel at $120 had high risk  Most investors and managers don’t like risk
 The maximum risk acceptable depends on the investor’s aversion to risk
 The higher the risk, the higher the required return

METHODS OF DEALING WITH RISK

 Compute the Expected Value, Standard Deviation, and Coefficient of Variation

 Compare the risk of the investment to the company’s Beta
 Increase the discount rate for riskier projects
 Certainty equivalents - adjust cash flows estimates for risk
 Use computer simulations to generate a range of possible outcomes with standard deviations
 Sensitivity analysis - How much does NPV change when one item in forecast changes?
 Use decision tree to compare the return and risk of alternate investments
 Coefficient of Correlation - How will an investment change the overall risk of the firm?

Statistical Measurement of Risk

Expected Value: D = ∑ DP

 equals the weighted average of possible outcomes (forecasts) times their probabilities
 Gives you the most likely forecast / your best estimate
2
Standard Deviation: σ = √∑ (D – D) P

 measure of dispersion or variability around the expected value

 gives you a measure of the spread of possible outcomes
 larger the standard deviation  greater the risk

Coefficient of Variation: (V)= σ/ D

 equal to standard deviation / expected value

 allows you to compare different investments
 larger the coefficient of variation  greater the risk

1
BETA - Beta is a statistical measure of volatility

 It measures how responsive or sensitive a company’s stock is to market movements in general

 An individual stock’s beta shows how it compares to the market as a whole:
o beta = 1 means equal risk with the market
o beta > 1 means more risky than the market
o beta < 1 means less risky than the market

Examples of BETA numbers

Company Name Beta

Bombardier 1.17
Canadian Tire 0.23
Power Corp 0.99
Potash Corp 0.67
Royal Bank 1.01

RISK AND THE CAPITAL BUDGETING PROCESS

 The expected inflows from capital projects usually are risky

 Cash flows of projects bearing a normal amount of risk undertaken by the firm should be discounted
at the cost of capital.
 The required rate of return of lenders and investors increases as the risk they are subjected to
increases.
 The cost of capital is composed of two components: the risk-free rate (time value of money only)
and a risk premium (risk associated with usual projects of a business)

Adjustments in the valuation for projects with risk

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.
2. The CAPM may be helpful in establishing an appropriate discount rate based on a project’s risk.
3. Certainty equivalent approach: recognition of differing risk levels is made by multiplying the
expected cash flow by a percentage figure indicating degree of certainty and discounting at the risk-
free rate.

RELATIONSHIP OF RISK TO DISCOUNT

RATE

2
RISK CATEGORIES AND ASSOCIATED DISCOUNT RATES

Discount Rate
Low or no risk (repair to old machine) 6%
Moderate risk (new equipment) 8
Normal risk (addition to normal product line) 10
Risky (new product in related market) 12
High risk (completely new market) 16
Highest risk (new product in foreign market) 20

SIMULATION MODEL – Various values for economic and financial variables affecting the capital
budgeting decision are randomly selected and used as inputs in the simulation model.

SENSITIVITY ANALYSIS – adjusts analytical model one variable at a time to identify key variables for
further investigation

DECISION TREES - The sequential pattern of decisions and resulting outcomes and associated
probabilities (managerial estimates based on experience and statistical process) are tracked along the
branches of the decision tree.

PORTFOLIO EFFECT - Considers the impact of a given investment on the overall risk of the firm

3
A firm may plan to invest in the building products industry carrying a high degree of risk

 The overall risk exposure of that firm might diminish

 The investing firm could alter cyclical fluctuations inherent in its business and reduce overall risk
exposure
 Thus, standard deviation for the entire company has been reduced

PORTFOLIO RISK – Risk is reduced by diversification and increased by correlation

The Coefficient of Correlation

 Shows extent of correlation among projects

 Has a numerical value of between -1 and +1
 Value shows the risk reduction between projects:
o Negative correlation (-1)  Large risk reduction
o No correlation (0)  Some risk reduction
o Positive correlation (+1)  No risk reduction

When 2 or more investments (A and B) are put together, they form a portfolio, and we are interested in
the return (expected value) and its risk (standard deviation)

Whether a given investment changes the overall risk of the firm depends on its relationships to other
investments. The expected value calculation is a straightforward weighted average:

D̅ p = Σxi D̅ i
Where xi = % weighting in the portfolio of each investment and D̅ = expected value of each investment.

Standard Deviation for a portfolio requires the variance of the individual investments and their
relationship with each other. Relationship is measured by covariance

CovAB = ΣP(D – D̅ i)(F – F̅i)

D and F represent the range of expected outcomes for the investments

Covariance – brought to a standardized scale known as the coefficient of correlation when divided by
the standard deviations of the 2 investments.

Coefficient of correlation will range from -1 to +1. Formula is:

Coefficient of Condition Example Impact on Risk

Correlation
-1 Negative correlation Electronic components, Large Risk Reduction
Food products
0 No correlation Beer, textiles Some risk reduction
+1 Positive correlation Two airlines No risk reduction

The standard deviation of a portfolio (AB) of 2 assets requires 2 variances and 2 covariances.

4
If we rearrange the earlier formula and substitute into the one above we get:

Highly correlated investments like 2 airlines that move in the same direction will have a coefficient of
correlation close to +1 and do little to diversify away risk.

Projects moving in opposite directions like food products and electronic components will likely be
negatively correlated with a coefficient of correlation approaching -1 and will provide a high degree of
risk reduction.

A reduced correlation coefficient (especially a negative value) will lower the standard deviation of the
portfolio.

EFFICIENT FRONTIER - Firm chooses combinations of projects with the best trade-off between risk and
return

2 objectives of management:

 Achieve the highest possible return at a given risk level

 Provide the lowest possible risk at a given return level

The Efficient Frontier is the best risk-return line or combination of possibilities

Firm must decide where to be on the line (there is no “right” answer)

SHARE PRICE EFFECT

1. 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.
2. 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.

SUMMARY

 Risk is considered as the variability of the potential outcomes from an investment

 Managers tend to be risk-adverse
 Methods of incorporating risk in capital budgeting include standard deviation and coefficient of
variation, risk-adjusted discount rates, certainty equivalents, simulation models, sensitivity analysis,
and decision trees
 The portfolio effect considers the effect of a new investment on the overall risk of the firm