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# CHAPTER 11

## Capital Budgeting and Risk Analysis

CHAPTER ORIENTATION
The focus of this chapter will be on how to adjust for the riskiness of a given project or combination of projects.

CHAPTER OUTLINE
I. Risk and the investment decision A. Up to this point we have treated the expected cash flows resulting from an investment proposal as being known with perfect certainty. We will now introduce risk. The riskiness of an investment project is defined as the variability of its cash flows from the expected cash flow. In capital budgeting, a project can be looked at on three levels. 1. First, there is the project standing alone risk, which is a projects risk ignoring the fact that much of this risk will be diversified away as the project is combined with the firms other projects and assets. Second, we have the projects contribution-to-firm risk, which is the amount of risk that the project contributes to the firm as a whole; this measure considers the fact that some of the projects risk will be diversified away as the project is combined with the firms other projects and assets, but ignores the effects of diversification of the firms shareholders. Finally, there is systematic risk, which is the risk of the project from the viewpoint of a well-diversified shareholder; this measure considers the fact that some of a projects risk will be diversified away as the project is combined with the firms other projects, and, in addition, some of the remaining risk will be diversified away by shareholders as they combine this stock with other stocks in their portfolio.

B. II.

## What measure of risk is relevant in capital budgeting. A.

2.

3.

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B.

Because of bankruptcy costs and the practical difficulties involved in measuring a projects level of systematic risk, we will give consideration to the projects contribution-to-firm risk and the projects systematic risk. The certainty equivalent approach involves a direct attempt to allow the decision maker to incorporate his or her utility function into the analysis. 1. 2. In effect, a riskless set of cash flows is substituted for the original set of cash flows between which the financial manager is indifferent. To simplify calculations certainty equivalent coefficients ( are t's) defined as the ratio of the certain outcome to the risky outcome between which the financial manager is indifferent. Mathematically, certainty equivalent coefficients can be defined as follows: t 4. = certain cash flow t risky cash flow t

III.

## Methods for incorporating risk into capital budgeting A.

3.

The appropriate certainty equivalent coefficient is multiplied by the original cash flow (which is the risky cash flow) with this product being equal to the equivalent certain cash flow. Once risk is taken out of the cash flows, those cash flows are discounted back to present at the risk-free rate of interest and the project's net present value or profitability index is determined. If the internal rate of return is calculated, it is then compared with the risk-free rate of interest rather than the firm's required rate of return. Mathematically, the certainty equivalent can be summarized as follows: NPV where t = =

5.

6. 7.

t =1

(1t+ i

ACFt
t F)

- IO

the certainty equivalent coefficient for time period t the annual after-tax expected cash flow in time period t the initial cash outlay the project's expected life the risk-free interest rate

ACFt = IO n iF = = =

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B.

The use of the risk-adjusted discount rate is based on the concept that investors demand higher returns for more risky projects. 1. If the risk associated with the investment is greater than the risk involved in a typical endeavor, then the discount rate is adjusted upward to compensate for this risk. The expected cash flows are then discounted back to present at the risk-adjusted discount rate. Then the normal capital budgeting criteria are applied, except in the case of the internal rate of return, in which case the hurdle rate to which the project's internal rate of return is compared now becomes the risk-adjusted discount rate. Expressed mathematically the net present value using the risk-adjusted discount rate becomes NPV where ACFt IO i* n = = = = =
t (1 + i*) t n

2.

3.

ACF

- IO

t =1

the annual after-tax cash flow in time period t the initial outlay the risk-adjusted discount rate the project's expected life

IV.

Methods for measuring a project's systematic risk A. Theoretically, we know that systematic risk is the "priced" risk, and thus, the risk that affects the stock's market price and thus the appropriate risk with which to be concerned. However, if there are bankruptcy costs (which are assumed away by the CAPM), if there are undiversified shareholders who are concerned with more than just systematic risk, if there are factors that affect a security's price beyond what the CAPM suggests, or if we are unable to confidently measure the project's systematic risk, then the project's individual risk carries relevance. Moreover, in general, a project's individual risk is highly correlated with the project's systematic risk, making it a reasonable proxy to use. In spite of problems in confidently measuring an individual firm's level of systematic risk, if the project appears to be a typical one for the firm, then using the CAPM to determine the appropriate risk return tradeoffs and then judging the project against them may be a warranted approach. If the project is not a typical project, we are without historical data and must either estimate the beta using accounting data or use the pure-play method for estimating beta. 1. Using historical accounting data to substitute for historical price data in estimating systematic risk: To estimate a project's beta using accounting data we need only run a time series regression of the

B.

C.

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division's return on assets on the market index. The regression coefficient from this equation would be the project's accounting beta and serves as an approximation for the project's true beta. 2. The pure play method for estimating a project's beta: The pure play method attempts to find a publicly traded firm in the same industry as the capital-budgeting project. Once the proxy or pure-play firm is identified, its systematic risk is determined and then used as a proxy for the project's systematic risk.

V.

Additional approaches for dealing with risk in capital budgeting A. A simulation imitates the performance of the project being evaluated by randomly selecting observations from each of the distributions that affect the outcome of the project, combining those observations to determine the final output of the final project, and continuing with this process until a representative record of the project's probable outcome is assembled. 1. The firm's management then examines the resultant probability distribution, and if management considers enough of the distribution lies above the normal cutoff criterion, it will accept the project. The use of a simulation approach to analyze investment proposals offers two major advantages: a. The financial managers are able to examine and base their decisions on the whole range of possible outcomes rather than just point estimates. They can undertake subsequent sensitivity analysis of the project.

2.

b. B.

A probability tree is a graphical exposition of the sequence of possible outcomes; it presents the decision maker with a schematic representation of the problem in which all possible outcomes are graphically displayed. Many times, especially with the introduction of a new product, the cash flows experienced in early years affect the size of the cash flows experienced in later years. This is called time dependence of cash flows, and it has the effect of increasing the riskiness of the project over time.

VI.

## Other sources and measures of risk A.

11-1. The payback period method is frequently used as a rough risk screening device to eliminate projects whose returns do not materialize until later years. In this way, the earliest returns are emphasized, which in all likelihood have less uncertainty surrounding them.

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11-2.

The use of the risk-adjusted discount rate assumes that risk increases over time. When using the risk-adjusted discount rate method, we are adjusting downward the value of future cash flows that occur later in the future more severely than earlier ones. This assumption can be justified because flows that are expected further out in the future are more difficult to forecast and less certain than are flows that are expected in the near future.

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## SOLUTIONS TO END-OF-CHAPTER PROBLEMS

Solutions to Problem Set A
11-1A. (a) A = Xi P(Xi)
N

i =1

= \$4,000 (0.15) + \$5,000 (0.70) + \$6,000 (0.15) = \$600 + \$3,500 + \$900 = \$5,000

= \$2,000 (0.15) + \$6,000 (0.70) + \$10,000 (0.15) = \$300 + \$4,200 + \$1,500 = \$6,000

(b)

NPV NPVA

t =1

ACFt (1 + i*) t

- I0

NPVB

## = \$6,000 (3.352) - \$10,000 = \$20,112 - \$10,000 = \$10,112

(c)

One might also consider the potential diversification effect associated with these projects. If the project's cash flow patterns are cyclically divergent from those of the company, the overall risk of the company may be significantly reduced.

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11-2A. (a) A

i =1

Xi P(Xi)

= \$35,000 (0.10) + \$40,000 (0.40) + \$45,000 (0.40) + \$50,000 (0.10) = \$3,500 + \$16,000 + \$18,000 + \$5,000 = \$42,500 = \$10,000 (0.10) + \$30,000 (0.20) + \$45,000 (0.40) + \$60,000 (0.20) + \$80,000 (0.10) = \$1,000 + \$6,000 + \$18,000 + \$12,000 + \$8,000 = \$45,000

(b)

NPV NPVA

t =1

ACFt (1 + i*) t

- IO

NPVB

## = \$45,000 (3.517) - \$100,000 = \$158,265 - \$100,000

(c)

= \$58,265 One might also consider the potential diversification effect associated with these projects. If the project's cash flow patterns are cyclically divergent from those of the company, the overall risk of the company may be significantly reduced.

11-3A. Project A: (A) Year 0 1 2 3 4 Expected Cash Flow -\$1,000,000 500,000 700,000 600,000 500,000 (B) t 1.00 .95 .90 .80 .70 (A x B) Present Value (Expected Factor at Present Cash Flow ) (t) 5% Value -\$1,000,000 1.000 -\$1,000,000 475,000 .952 452,200 630,000 .907 571,410 480,000 .864 414,720 350,000 .823 288,050 NPVA = \$ 726,380

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Project B: (A) Year 0 1 2 3 4 Expected Cash Flow -\$1,000,000 500,000 600,000 700,000 800,000 (B) t 1.00 .90 .70 .60 .50 (A x B) (Expected Cash Flow ) (t) -\$1,000,000 450,000 420,000 420,000 400,000 Present Value Factor at Present 5% Value 1.000 -\$1,000,000 .952 428,400 .907 380,940 .864 362,880 .823 329,200 NPVB = \$ 501,420

Thus, project A should be selected, as it has a higher NPV. 11-4A. (A) Year 0 1 2 3 4 5 Expected Cash Flow -\$90,000 25,000 30,000 30,000 25,000 20,000 (B) t 1.00 0.95 0.90 0.83 0.75 0.65 (A x B) (Expected Cash Flow ) (t) -\$90,000 23,750 27,000 24,900 18,750 13,000 Present Value Factor at Present 7% Value 1.000 -\$90,000 .935 22,206 .873 23,571 .816 20,318 .763 14,306 .713 9,269 NPV = \$ -330

Thus, this project should not be accepted because it has a negative NPV. 11-5A. NPVA =
t =1

ACFt (1 + i*) t

- I0

= \$30,000 (.893) + \$40,000(.797) + \$50,000(.712) + \$90,000(.636) + \$130,000(.567) - \$250,000 = \$26,790 + \$31,880 + \$35,600 + \$57,240 + \$73,710 - \$250,000 = - \$24,780 NPVB =
t =1 N

ACF (1 + i*) t

- I0

## = \$135,000(3.127) - \$400,000 = \$422,145 - \$400,000 = \$22,145

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11-6A. Project A: (A) Year 0 1 2 3 4 Expected Cash Flow -\$ 50,000 15,000 15,000 15,000 45,000 Project B: (A) Year 0 1 2 3 4 Expected Cash Flow -\$ 50,000 20,000 25,000 25,000 30,000 (B) t 1.00 .90 .85 .80 .75 (A x B) (Expected Cash Flow ) (t) -\$ 50,000 18,000 21,250 20,000 22,500 Present Value Factor at Present 6% Value 1.000 -\$ 50,000.00 .943 16,974.00 .890 18,912.50 .840 16,800.00 .792 17,820.00 NPVB = \$ 20,506.50 (B) t 1.00 .95 .85 .80 .70 (A x B) (Expected Cash Flow ) (t) -\$ 50,000 14,250 12,750 12,000 31,500 Present Value Factor at Present 6% Value 1.000 -\$ 50,000.00 .943 13,437.75 .890 11,347.50 .840 10,080.00 .792 24,948.00 NPVA = \$ 9,813.25

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## Internal Rate of Return for 0 Year

11-7A. (a c)

1 Year
p = 0.3 p = 0.6 \$700,000 P = 0.1

## 2 Years \$300,000 \$700,000 \$1,100,000

Joint each Branch -12.95% 10.92% 29.25% 3.15% 19.61% 33.33% 45.36% 23.74% 37.77% 46.08%

Probability 0.18 0.36 0.06 0.06 0.15 0.06 0.03 0.01 0.05 0.04 1.00

(A)(B) -2.33% 3.93% 1.76% 0.19% 2.94% 2.00%] 1.36% 0.24% 1.89% 1.84%

## \$400,000 \$700,000 \$1,000,000

p = 0.1

284

p = 0.1 p = 0.1

\$1,300,000 \$600,000
p = 0.5

\$900,000 \$1,100,000

\$1,000,000 p = 0.4

Expected internal rate of return d. The range of possible IRRs from 12.95% to 46.08%

13.82%

## Internal Rate of Return for 0 Year 1 Year

p = 0.5 p = 0.5 \$200,000 p = 0.3 p = 0.5 p = 0.5 p = 0.5 \$175,000 p = 0.6 \$100,000 p = 0.2 p = 0.5 \$-100,000 p = 0.5 \$150,000 p = 0.4 p = 0.6 \$10,000 \$10,000 p = 1.0 p = 0.4 \$0 p = 1.0

11-8A. (a c)

2 Years \$230,000

Probability 0.09

(A)(B) 11.72%

\$180,000

124.68%

0.09

11.22%

\$205,000

121.09%

0.15

18.16%

\$155,000

114.96%

0.15

17.24%

285

\$180,000

111.30%

0.06

6.68%

\$130,000

104.46%

0.06

6.27%]

\$10,000

-42.44%

0.24

-10.19%

\$0

-90.007%

0.16

-14.40% 46.70%

## SOLUTIONS TO INTEGRATIVE PROBLEM

2.

3.

4.

5.

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observations and determining the final outcome of the project, and continuing with this process until a representative record of the project's probable outcome is assembled. In effect, the output from a simulation is a probability distribution of net present values or internal rates of return for the project. The decision maker then bases his decision on the full range of possible outcomes. 6. Sensitivity analysis involves determining how the distribution of possible net present values or internal rates of return for a particular project is affected by a change in one particular input variable. This is done by changing the value of one input variable while holding all other input variables constant. The time dependence of cash flows refers to the fact that, many times, cash flows in later periods are dependent upon the cash flows experienced in earlier periods. For example, if a new product is introduced and the initial public reaction is poor, resulting in low initial cash flows, then cash flows in future periods are likely to be low also. Examples include the introduction of any new products, for example, the Edsel on the negative side, and hopefully this book on the positive side. 8. Project A: (A) Year 0 1 2 3 4 Project B: (A) Year (B) (A x B) (Expected Cash Flow ) (t) 1.00 -\$200,000 .95 47,500 .85 51,000 .80 48,000 .75 37,500 Present Value Factor at Present 7% Value 1.000 -\$200,000 .935 44,413 .873 44,523 .816 39,168 .763 28,613 NPVB = - \$ 43,283 (B) Expected Cash Flow -\$150,000 40,000 40,000 40,000 100,000 (A x B) t 1.00 .90 .85 .80 .70 (Expected Cash Flow ) (t) -\$150,000 36,000 34,000 32,000 70,000 Present Value Factor at 7% Present Value

7.

1.000 -\$150,000 .935 33,660 .873 29,682 .816 26,112 .763 53,410 NPVA = - \$ 7,136

## Expected Cash Flow t 0 -\$200,000 1 50,000 2 60,000 3 60,000 4 50,000

Thus, neither project should be selected, as they both have negative NPVs..

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## Internal Rate of Return for 0 Year

Part 9

1 Year
p = 0.3 p = 0.7 \$300,000

2 Years \$200,000

Probability 0.12

(A)(B) -1.45%

\$300,000

0.00%

0.28

0.00%

## p = 0.4 p = 0.2 p = 0.5 p = 0.3 \$350,000

\$250,000

0.00%

0.08

0.00%

p = 0.4 -\$600,000

\$450,000

20.55%

0.20

4.11%

288

\$650,000
p = 0.2

37.26%

0.12

4.47%

p = 0.2

\$300,000

17.54%

0.04

0.70%]

\$500,000
p =0.5

36.19%

0.10

3.62%

\$700,000

51.84%

0.04

2.07%

\$1,000,000

71.94%

0.02 1.00

1.44%

14.96%

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## Solutions to Problem Set B

11-1B. (a) X XA = = = = XB = = = (b) NPV =
i =1

Xi P(Xi)

\$5,000 (0.20) + \$6,000 (0.60) + \$7,000 (0.20) \$1,000 + \$3,600 + \$1,400 \$6,000 \$3,000 (0.20) + \$7,000 (0.60) + \$11,000 (0.20) \$600 + \$4,200 + \$2,200 \$7,000
N

ACFt (1 + i*) t

t =1

- I0

## NPVA = = = NPVB = = = (c)

\$6,000 (3.517) - \$10,000 \$21,102 - \$10,000 \$11,102 \$7,000 (3.127) - \$10,000 \$21,889 - \$10,000 \$11,889

One might also consider the potential diversification effect associated with these projects. If the project's cash flow patterns are cyclically divergent from those of the company, the overall risk of the company may be significantly reduced.

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11-2B. (a)

X XA

= =

i =1

Xi P(Xi)

## \$40,000 (0.10) + \$45,000 (0.40) + \$50,000 (0.40) + \$55,000 (0.10)

= = XB =

\$4,000 + \$18,000 + \$20,000 + \$5,500 \$47,500 \$20,000 (0.10) + \$40,000 (0.20) + \$55,000 (0.40) + \$70,000 (0.20) + \$90,000 (0.10)

= = (b) NPV =

N

ACFt (1 + i*) t

t =1

- I0

## NPVA = = = NPVB = = = (c)

\$47,500 (3.696) - \$125,000 \$175,560 - \$125,000 \$50,560 \$55,000 (3.517) - \$125,000 \$193,435 - \$125,000 \$68,435

One might also consider the potential diversification effect associated with these projects. If the project's cash flow patterns are cyclically divergent from those of the company, the overall risk of the company may be significantly reduced.

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11-3B. Project A: (A) Year 0 1 2 3 4 (B) Expected Cash Flow -\$1,000,000 600,000 750,000 600,000 550,000 (A x B) t 1.00 .90 .90 .75 .65 (Expected Cash Flow ) x (t) -\$1,000,000 540,000 675,000 450,000 357,500 Present Value Factor at Present 5% Value 1.000 -\$1,000,000 .952 514,080 .907 612,225 .864 388,800 .823 294,222.50 NPVA = \$ 809,327.50

Project B: (A) Year 0 1 2 3 4 (B) Expected Cash Flow -\$1,000,000 600,000 650,000 700,000 750,000 (A x B) t 1.00 .95 .75 .60 .60 (Expected Cash Flow ) x (t) -\$1,000,000 570,000 487,500 420,000 450,000 Present Value Factor at Present 5% Value 1.000 -\$1,000,000 .952 542,640 .907 442,162.50 .864 362,880 .823 370,350 NPVB = \$ 718,032.50

Thus, project A should be selected, as it has a higher NPV. 11-4B. (A) (B) Expected Cash Flow -\$100,000 30,000 25,000 30,000 20,000 25,000 (A x B) t 1.00 0.95 0.90 0.83 0.75 0.65 Present Value (Expected Factor at Present Cash Flow ) .( t) 8% Value -\$100,000 1.000 -\$100,000 28,500 .926 26,391 22,500 .857 19,283 24,900 .794 19,771 15,000 .735 11,025 16,250 .681 11,066 NPV = -\$ 12,465

Year 0 1 2 3 4 5

Thus, this project should not be accepted because it has a negative NPV.

36

11-5B. NPVA = = = = NPVB = = = = 11-6B. Project A: (A) Year 0 1 2 3 4 Project B: (A) Year 0 1 2 3 4 (B) Expected Cash Flow -\$ 75,000 25,000 30,000 30,000 25,000 (A x B) t 1.00 .95 .85 .80 .75 (Expected Cash Flow ) x (t) -\$ 75,000 23,750 25,500 24,000 18,750 Factor at 7% Present Value Present Value (B) Expected Cash Flow -\$ 75,000 20,000 20,000 15,000 50,000 (A x B) t 1.00 .95 .85 .80 .70 Present Value (Expected Factor at Present Cash Flow ) x (t) 7% Value -\$ 75,000 1.000 -\$ 75,000.00 19,000 .935 17,765.00 17,000 .873 14,841.00 12,000 .816 9,792.00 35,000 .763 26,705.00 NPVA = (\$ 5,897.00)
t =1

ACFt (1 + i*) t

- IO

\$30,000 (.885) + \$40,000(.783) + \$50,000(.693) + \$80,000(.613) + \$120,000(.543) - \$300,000 \$26,550 + \$31,320 + \$34,650 + \$49,040 + \$65,160 - \$300,000 - \$93,280
t =1 N

ACF (1 + i*) t

- IO

## \$130,000(3.127) - \$450,000 \$406,510 - \$450,000 -\$43,490

1.000 -\$ 75,000.00 .935 22,206.25 .873 22,261.50 .816 19,584.00 .763 14,306.25 NPVB = \$ 3,358.00

## of Return for 0 Year

1 Year
p = 0.1 p = 0.5 \$750,000 p = 0.4

## 2 Years \$300,000 \$700,000 \$1,100,000 \$400,000 \$700,000 \$900,000

p = 0.1

Internal Rate Joint each Branch -15.12% 7.69% 25.25% 0.00% 15.75% 24.73% 40.44% 46.82% 58.94% 66.27%

11-7B. (a c)

Probability 0.06 0.30 0.24 0.06 0.15 0.06 0.03 0.03 0.06 0.01 1.00

(A)(B) -0.9072% 2.3070% 6.0600% 0.0000% 2.3625% 1.4838%] 1.2132% 1.4046% 3.5364% 0.6627%

293

-\$900,000

p = 0.1

## p = 0.3 p = 0.6 \$1,500,000

p = 0.1

Expected internal rate of return (d) The range of possible IRRs from -15.12% to 66.27

18.1230%

39

## of Return for 0 Year

1 Year
p = 0.5 p = 0.5 \$225,000 p = 0.3 p = 0.5 p = 0.5 p = 0.5 \$180,000 p = 0.2 p = 0.5

2 Years \$255,000

11-8B. (a c)

Probability .105

(A)(B) 12.16227%

\$205,000

110.76%

.105

11.6298%

\$210,000

101.15%

.175

17.7013%

## p = 0.7 \$100,000 \$-120,000

\$160,000

95.18%

.175

16.6565%

294
p = 0.3

\$170,000
p = 0.5 \$140,000 p = 0.6 \$10,000 \$10,000 p = 1.0 p = 0.4 \$0 p = 1.0

86.57%

.070

6.0599%

\$120,000

79.42%

.070

5.5594%]

\$10,000

-46.70%

.180

-8.4060%

\$0

-91.67%

.120 1.00 =

-11.0004% 50.3627%

Expected internal rate of return (d) The range of possible IRRs from 91.67% to 115.83%

MADE IN THE U. S. A., DUMPED IN BRAZIL, AFRICA, . . . (Ethics in Capital Budgeting) OBJECTIVE: To force the student to recognize the role ethical behavior plays in all areas of Finance. Easy

## DEGREE OF DIFFICULTY: Case Solution:

With ethics cases there are no right or wrong answers - just opinions. Try to bring out as many opinions as possible without being judgmental. In this case the question centers around what to do when a product is no longer sellable.

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