Rushen Chahal
CHAPTER 11
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.
2.
3.
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III.
2.
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 approach can be summarized as follows: NPV where t = =
5.
6. 7.
t =1
t FCFt - IO (1 + k rf ) t
the certainty equivalent coefficient for time period t the annual expected free cash flow in time period t the initial cash outlay the project's expected life the risk-free interest rate
FCFt = IO n krf = = =
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2.
3.
t =1
FCFt - IO (1 + k*) t
the annual expected free cash flow in time period t the initial outlay the risk-adjusted discount rate the project's expected life
Methods for measuring a project's systematic risk 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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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 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.
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11-3. The primary difference between the certainty equivalent approach and the riskadjusted discount rate approach is where the adjustment for risk is incorporated into the calculations. The certainty equivalent approach penalizes or adjusts downwards the value of the expected annual free cash flows, while the risk-adjusted discount rate leaves the cash flows at their expected value and adjusts the required rate of return, k, upwards to compensate for added risk. In either case the net present value of the project is being adjusted downwards to compensate for additional risk. An additional difference between these methods is that the risk-adjusted discount rate assumes that risk increases over time and that cash flows occurring later in the future should be more severely penalized. The certainty equivalent method, on the other hand, allows each cash flow to be treated individually. 11-4. A probability tree is a graphical exposition of the sequence of possible outcomes, presenting the decision maker with a schematic representation of the problem in which all possible outcomes are graphically displayed. Moreover, the computations and results of the computations are shown directly on the tree, so that the information can be easily understood. Thus the probability tree allows the manager to quickly visualize the possible future events, their probabilities, and outcomes. In addition, the calculation of the expected internal rate of return and enumeration of the distribution should aid the financial manager in his decision-making process. 11-5. The idea behind simulation is to imitate the performance of the project being evaluated. This is done by randomly selecting observations from each of the distributions that affect the outcome of the project, combining each of those 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. 11-6. 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.
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i =1
Xi P(Xi)
= $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
FCFt - I0 (1 + k*) t
NPVB
(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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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
FCFt - IO (1 + k*) t
NPVB
(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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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) Present Value (Expected Factor at Present Cash Flow ) (t) 7% Value -$90,000 1.000 -$90,000 23,750 .935 22,206 27,000 .873 23,571 24,900 .816 20,318 18,750 .763 14,306 13,000 .713 9,269 NPV = $ -330
Thus, this project should not be accepted because it has a negative NPV. 11-5A. NPVA =
n
t =1
= $30,000 (.893) + $40,000(.797) + $50,000(.712) = $26,790 + $31,880 + $35,600 + $57,240 + $73,710 - $250,000 = - $24,780 NPVB =
n
t =1
FCF - I0 (1 + k*) t
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11-7A. (a c)
1 Year
p = 0.3 p = 0.6 $700,000 P = 0.1
Joint each Branch -12.95% 10.92% 29.25% 3.15% 19.60% 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%
299
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
1 Year
2 Years
p = 0.5 p = 0.5 $200,000
3 Years $230,000
11-8A. (a c)
Probability 0.09
(A)(B) 11.72%
$180,000
124.68%
0.09
11.22%
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
$205,000
121.09%
0.15
18.16%
$155,000
114.96%
0.15
17.24%
300
d.
$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
-90.00%
0.16
-14.40% 46.70%
2.
3.
4.
5.
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7.
8.
1.000 -$150,000 .935 33,660 .873 29,682 .816 26,112 .763 53,410 NPVA = - $ 7,136
0 1 2 3 4
Thus, neither project should be selected, as they both have negative NPVs.
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Part 9
1 Year
p = 0.3
2 Years $200,000
p = 0.7
Probability 0.12
(A)(B) -1.45%
$300,000
0.00%
0.28
0.00%
$250,000
0.00%
0.08
0.00%
p = 0.4 -$600,000
$450,000
20.55%
0.20
4.11%
298
$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%
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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
t =1
FCFt - I0 (1 + k*) t
$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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i =1
Xi P(Xi)
= = 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 =
t =1
FCFt - I0 (1 + k*) t
$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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Project B: (A) Year 0 1 2 3 4 Expected Cash Flow -$100,000 600,000 650,000 700,000 750,000 (B) t 1.00 .95 .75 .60 .60 (A x B) (Expected Cash Flow ) (t) -$100,000 570,000 487,500 420,000 450,000 Present Value Factor at Present 5% Value 1.000 -$100,000 .952 542,640 .907 442,162.50 .864 362,880 .823 370,350 NPVB = $1,618,032.50
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 .( t) Cash Flow ) 8% Value -$100,000 1.000 -$100,000 28,500 .926 26,391 22,500 .857 19,283 24,900 .794 19,771 15,000 .735 11,025 16,250 .681 11,066 NPV = -$ 12,464
Year 0 1 2 3 4 5
Thus, this project should not be accepted because it has a negative NPV.
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t =1
$30,000 (.885) + $40,000(.783) + $50,000(.693) $26,550 + $31,320 + $34,650 + $49,040 + $65,160 - $300,000 - $93,280
n
t =1
FCF - IO (1 + k*) t
1.000 -$ 75,000.00 .935 22,206.25 .873 22,261.50 .816 19,584.00 .763 14,306.25 NPVB = $ 3,358.00
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1 Year
p = 0.1 p = 0.5 $750,000 p = 0.4
Internal Rate Joint each Branch -15.12% 7.69% 25.25% 0.00% 15.75%
11-7B. (a c)
303
-$1,300,000
$900,000 $1,300,000
p = 0.1
50
1 Year
2 Years
p = 0.5 p = 0.5 $225,000
3 Years $255,000
11-8B. (a c)
Probability .105
(A)(B) 12.16227%
$205,000
110.76%
.105
11.6298%
p = 0.3 p = 0.5 p = 0.5 p = 0.7 $100,000 -$120,000 $140,000 p = 0.3 p = 0.6 $10,000 $10,000 p = 1.0 p = 0.4 $0 p = 1.0 $180,000 p = 0.2 p = 0.5 p = 0.5
$210,000
101.15%
.175
17.7013%
$160,000
95.18%
.175
16.6565%
304
(d)
$170,000
p = 0.5
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 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
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 salable.
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