13

Risk and Capital

Budgeting
Block, Hirt, and Danielsen
Foundations of Financial Management
17th edition

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 Learning Objectives
• The concept of risk is based on uncertainty about future
outcomes. It requires the computation of quantitative
measures as well as qualitative considerations.
• Most investors are risk-averse, which means they dislike
uncertainty.
• Because investors dislike uncertainty, they will require higher
rates of return from risky projects.
• Simulation models and decision trees can be used to help
assess the risk of an investment.
• Not only must the risk of an individual project be considered,
but also how the project affects the total risk of the firm.

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 Definition of Risk
in Capital Budgeting

• Risk defined in terms of variability of possible

outcomes from given investment
• Risk is measured in terms of losses and
uncertainty

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 Figure 13-1 Variability and Risk
• Three investment proposals illustrated in
following slide
• Each with different risk characteristics
• All investments in illustration have same
expected value of $20,000
• Investment C is most risky of the three due to
variability

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 Figure 13-1 Variability and
Risk Continued

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 The Concept of Risk-Averse
• Most investors and managers are risk-averse
• Prefer relative certainty as opposed to uncertainty
• Investors require a higher expected value or
return for risky investments
• Figure 13-2 Risk-Return Trade-Off

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 Figure 13-2 Risk-Return Trade-Off

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 Actual Measurement of Risk
• Basic statistical devices used to measure the
extent of risk in any given situation
• Expected value: D =å DP
• Standard deviation: s = å (D – D)2 P
• Coefficient of variation: (V ) =s ¸ D

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 Table 13-1 Probability Distribution of
Outcomes

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 Figure 13-3 Probability Distribution
with Differing Degrees of Risk

• Larger standard deviation means greater risk

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 Figure 13-4 Probability Distribution
with Differing Degrees of Risk

• Direct comparison of standard deviations not helpful if expected

values of investments differ
• Standard deviation of $600 with expected value of $6,000
indicates less risk than standard deviation of $190 with expected
value of $600
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 Actual Measurement of Risk
•  Coefficient of Variation (V)
• Size difficulty can be eliminated by introducing
coefficient of variation (V)
• Formula:
• The larger the coefficient, the greater the risk

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 Actual Measurement of Risk Continued

• Risk Measure—Beta (β)

• Widely used with portfolios of common stock
• Measures volatility of returns on individual stock
relative to returns on stock market index
• A common stock with a beta of 1.0 is said to be of equal
risk with the market

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 Table 13-2 Average Betas for a Five-
Year Period (Ending January 2018)

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 Risk and the Capital Budgeting Process
• Informed investor or manager differentiates
between
• Investments that produce “certain” returns
• Investments that produce expected value of
return, but have high coefficient of variation

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 Risk-Adjusted Discount Rate
• Different capital-expenditure proposals with
different risk levels require different discount
rates
• Project with normal amount of risk should be
discounted at cost of capital
• Project with greater than normal risk should be
discounted at higher rate
• Risk assumed to be measured by coefficient of
variation (V)

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 Figure 13-5 Relationship of Risk
to Discount Rate

• Example of
increasing
risk-aversion
at higher
levels of risk
and potential
return

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 Increasing Risk over Time
• Accurate forecasting becomes more difficult
farther out in time
• Unexpected events
• Create higher standard deviation in cash flows
• Increase risk associated with long-lived projects
• Figure 13-6 Risk over Time
• Depicts the relationship between risk and time

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 Figure 13-6 Risk over Time

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 Qualitative Measures and Table 13-3
• Setting up risk classes based on qualitative
considerations
• Raising discount rate to reflect perceived risk
• Table 13-3 Risk Categories and Associated
Discount Rates

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 Table 13-4 Capital Budgeting Analysis

• Investment B preferred based on NPV calculation

without considering risk factor

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 Capital Budgeting Decision
Adjusted for Risk—Example
• Assume
• Investment A calls for addition to normal product
line, assigned 10 percent discount rate
• Investment B represents new product in foreign
market, must carry 20 percent discount rate to
adjust for large risk component

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 Table 13-5 Capital Budgeting Decision
Adjusted for Risk

• Investment A is only acceptable alternative after

adjusting for risk factor
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 Simulation Models
• Deal with uncertainties involved in forecasting
outcome of capital budgeting projects or other
decisions
• Computers enable simulation of various economic
and financial outcomes using number of variables
• Monte Carlo model uses random variables for inputs
• Rely on repetition of same random process as
many as several hundred times

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 Simulation Models Continued
• Have ability to test various combinations of
events
• Used to test possible changes in variable
conditions included in process (real world)
• Allow planner to ask “what if” questions
• Driven by sales forecasts, with assumptions to
derive income statements and balance sheets
• Generate probability acceptance curves for
capital budgeting decisions
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 Figure 13-7 Simulation Flow Chart

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 Decision Trees

• Help lay out sequence of possible decisions

• Present tabular or graphical comparison between
investment choices
• Branches of tree highlights the differences
between investment choices
• Provide important analytical process

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 Decision Trees Continued
• Assume a firm is considering two choices
• Project A—opening additional physical stores in a new
geographic region but using a format that has already
proven successful elsewhere
• Project B—developing a new online-only retail venture
• Both projects cost $60 million, with different net
present value (NPV) and risk
• Project A—High likelihood of modest positive rate of return,
reasonable expectation of long-term growth
• Project B—Stiff competition may result in loss of more money or
higher profit if sales high

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 Table 13-6 Decision Trees

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 The Portfolio Effect
• Considers impact of given investment proposal
on overall firm risk
• Firm planning to invest in building products
industry that carries high degree of risk
• Primary business in manufacture of electronic
components for industrial use
• Investing firm could alter cyclical fluctuations inherent
in primary business and reduce overall risk exposure
• Could reduce standard deviation for entire company
• Risk reduction demonstrated by less dispersed
probability distribution

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 Portfolio Risk
• Investment may change overall risk of firm
depending on relationship to other
investments
• Highly correlated investments move in the same
direction in good and bad times, do not diversify
against risk
• Negatively correlated investments move in
opposite directions and are a greater risk
reduction
• Uncorrelated investments provide some risk
reduction
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 Figure 13-8 Portfolio Considerations in
Evaluating Risk

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 Coefficient of Correlation
• Represents extent of correlation among
various projects and investments
• May take on values anywhere from –1 to +1
• Real world will produce a more likely measure,
between –0.2 negative correlation and +0.3
positive correlation
• Risk can be reduced
• Combining risky assets with low-risk or negatively
correlated assets

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 Table 13-7 Measures of Correlation

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 Figure 13-9 Levels of Risk Reduction as
Measured by the Coefficient of Correlation

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 Table 13-8 Rates of Return for Conglomerate Inc.
and Two Merger Candidates

• Merger with Negative Correlation Inc. appears to be

best decision
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 Evaluation of Combinations
• Two primary objectives in choosing between
various points or combinations
1. Achieve highest possible return at given risk level
2. Provide lowest possible risk at given return level
• Determining position of firm on efficient
frontier
• Where on the line the firm should be
• Willingness to take larger risks for superior returns
• Make conservative selection

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 Figure 13-10 Risk-Return Trade-Offs

• Best opportunities fall along leftmost sector (line C–F–G)

• Points to right less desirable

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 The Share Price Effect
• Firm must be sensitive to wishes and demands
of shareholders
• When taking unnecessary or undesirable risks
• Higher discount rate and lower valuation may be
assigned to stock in market
• Higher profits from risky ventures could have a
result opposite from what intended
• Raising the firm’s risk could lower the overall
valuation of the firm

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