Chapter 12

Risk and
Refinements
in Capital
Budgeting
Learning Goals

LG1 Understand the importance of recognizing risk

in the analysis of capital budgeting projects.

LG2 Discuss risk and cash inflows, scenario analysis,

and simulation as behavioral approaches for
dealing with risk.

LG3 Review the unique risks that multinational

companies face.

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Learning Goals (cont.)

LG4 Describe the determination and use of risk-

adjusted discount rates (RADRs), portfolio
effects, and the practical aspects of RADRs.

LG5 Select the best of a group of unequal-lived,

mutually exclusive projects using annualized net
present values (ANPVs).

LG6 Explain the role of real options and the objective

and procedures for selecting projects under
capital rationing.

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Introduction to Risk in Capital Budgeting

Thus far, we have assumed that all investment

projects have the same level of risk as the firm.
In other words, we assumed that all projects are
equally risky, and the acceptance of any project
would not change the firms overall risk.
In actuality, these situations are rareprojects are
not equally risky, and the acceptance of a project
can affect the firms overall risk.

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Table 12.1 Cash Flows and NPVs for
Bennett Companys Projects

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Behavioral Approaches for Dealing with
Risk: Risk and Cash Inflows
Behavioral approaches can be used to get a feel
for the level of project risk, whereas other
approaches try to quantify and measure project
risk.
Risk (in capital budgeting) refers to the
uncertainty surrounding the cash flows that a
project will generate or, more formally, the degree
of variability of cash flows.
In many projects, risk stems almost entirely from
the cash flows that a project will generate several
years in the future, because the initial investment is
generally known with relative certainty.

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Behavioral Approaches for Dealing with
Risk: Risk and Cash Inflows (cont.)
Treadwell Tire Company, a tire retailer with a 10%
cost of capital, is considering investing in either of two
mutually exclusive projects, A and B. Each requires a
$10,000 initial investment, and both are expected to
provide constant annual cash inflows over their 15-
year lives. For either project to be acceptable its NPV
must be greater than zero.

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Behavioral Approaches for Dealing with
Risk: Risk and Cash Inflows (cont.)

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Behavioral Approaches for Dealing with
Risk: Risk and Cash Inflows (cont.)
For the projects to be acceptable, they must have annual
cash flows of at least $1,315. The risk of each project can
be assessed by determining the probability that the
projects cash flows will equal or exceed this breakeven
level. Assume that a statistical analysis results in the
following:

Because project A is certain to have a positive net present

value, whereas there is only a 65% change that project B
will have a positive NPV, project A seems less risky than
project B.

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Behavioral Approaches for Dealing with
Risk: Scenario Analysis
Scenario analysis is a behavioral approach that uses
several possible alternative outcomes (scenarios),
to obtain a sense of the variability of returns,
measured here by NPV.
In capital budgeting, one of the most common
scenario approaches is to estimate the NPVs
associated with pessimistic (worst), most likely
(expected), and optimistic (best) estimates of cash
inflow.
The range can be determined by subtracting the
pessimistic-outcome NPV from the optimistic-
outcome NPV.

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Table 12.2 Scenario Analysis of
Treadwells Projects A and B

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Behavioral Approaches for Dealing with
Risk: Simulation
Simulation is a statistics-based behavioral approach
that applies predetermined probability distributions
and random numbers to estimate risky outcomes.
By trying the various cash flow components
together in a mathematical model and repeating the
process numerous times, the financial manager can
develop a probability distribution of project returns.

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Figure 12.1 NPV Simulation

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International Risk Considerations

Exchange rate risk is the danger that an

unexpected change in the exchange rate between
the dollar and the currency in which a projects cash
flows are denominated will reduce the market value
of that projects cash flow.
In the short term, much of this risk can be hedged
by using financial instruments such as foreign
currency futures and options.
Long-term exchange rate risk can best be
minimized by financing the project in whole or in
part in the local currency.

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International Risk Considerations (cont.)

Political risk is much harder to protect against. Firms that

make investments abroad may find that the host-country
government can limit the firms ability to return profits back
home. Governments can seize the firms assets, or otherwise
interfere with a projects operation.
The difficulties of managing political risk after the fact make it
even more important that managers account for political risks
before making an investment.
They can do so either by adjusting a projects expected cash
inflows to account for the probability of political interference
or by using risk-adjusted discount rates in capital budgeting
formulas.

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International Risk Considerations (cont.)

Other special issues relevant for international capital

budgeting include:
Taxes
Transfer pricing
Strategic, rather than financial, considerations

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Risk-Adjusted Discount Rates

Risk-adjusted discount rates (RADR) are rates of

return that must be earned on a given project to
compensate the firms owners adequatelythat is, to
maintain or improve the firms share price.

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Risk-Adjusted Discount Rates:
Review of CAPM
The Capital Asset Pricing Model defines total risk as:

For assets traded in an efficient market, the

diversifiable risk, which results from uncontrollable or
random events, can be eliminated through
diversification. The relevant risk is therefore the
nondiversifiable risk, the risk for which owners of
these assets are rewarded. Nondiverifiable risk for
securities is commonly measured using beta, which is
an index of the degree of movement of an assets
return in response to a change in the market return.

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Risk-Adjusted Discount Rates:
Review of CAPM (cont.)
Using beta, bj, to measure the relevant risk of
any asset j, the CAPM is
rj = RF + [bj (rm RF)]
where

rj = required return on asset j

RF = risk-free rate of return
bj = beta coefficient for asset j
rm = return on the market portfolio of assets

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Risk-Adjusted Discount Rates:
Using CAPM to Find RADRs (cont.)
Figure 12.2 shows two projects, L and R.
Project L has a beta, bL, and generates an internal
rate of return, IRRL. The required return for a
project with risk bL is rL.
Because project L generates a return greater than that
required (IRRL > rL), project L is acceptable.
Project L will have a positive NPV when its cash inflows are
discounted at its required return, rL.
Project R, on the other hand, generates an IRR
below that required for its risk, bR (IRRR < rR).
This project will have a negative NPV when its cash inflows
are discounted at its required return, rR.
Project R should be rejected.

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Figure 12.2
CAPM and SML

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Risk-Adjusted Discount Rates:
Applying RADRs
Bennett Company wishes to apply the Risk-Adjusted
Discount Rate (RADR) approach to determine whether
to implement Project A or B. In addition to the data
presented earlier, Bennetts management assigned a
risk index of 1.6 to project A and 1.0 to project B as
indicated in the following table. The required rates of
return associated with these indexes are then applied
as the discount rates to the two projects to determine
NPV.

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Risk-Adjusted Discount Rates:
Applying RADRs (cont.)

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Risk-Adjusted Discount Rates:
Applying RADRs (cont.)
Because project A is riskier than project B, its RADR
of 14% is greater than project Bs 11%. The net
present value of each reflect that project B is
preferable because its risk-adjusted NPV is greater
than the risk-adjusted NPV for project A.

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Risk-Adjusted Discount Rates:
Applying RADRs (cont.)

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Risk-Adjusted Discount Rates:
Applying RADRs (cont.)

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Figure 12.3 Calculation of NPVs for
Bennett Companys Capital Expenditure
Alternatives Using RADRs

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Risk-Adjusted Discount Rates:
Portfolio Effects
As noted earlier, individual investors must hold
diversified portfolios because they are not rewarded
for assuming diversifiable risk.
Because business firms can be viewed as portfolios
of assets, it would seem that it is also important
that they too hold diversified portfolios.
Surprisingly, however, empirical evidence suggests
that firm value is not affected by diversification.
In other words, diversification is not normally
rewarded and therefore is generally not necessary.
Firms are not rewarded for diversification because
investors can diversify by holding securities in a
variety of firms.

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Table 12.3 Bennett Companys Risk
Classes and RADRs
Assume that the management of Bennett Company decided to
use risk classes to analyze projects and so placed each project in
one of four risk classes according to its perceived risk. The
classes ranged from I for the lowest-risk projects to IV for the
highest-risk projects.

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Risk-Adjusted Discount Rates:
RADRs in Practice (cont.)

The financial manager of Bennett has assigned project

A to class III and project B to class II. The cash flows
for project A would be evaluated using a 14% RADR,
and project Bs would be evaluated using a 10%
RADR. The NPV of project A at 14% was calculated in
Figure 12.3 to be $6,063, and the NPV for project B at
a 10% RADR was shown in Table 12.1 to be $10,924.
Clearly, with RADRs based on the use of risk classes,
project B is preferred over project A.

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Capital Budgeting Refinements:
Comparing Projects With Unequal Lives
The financial manager must often select the best of
a group of unequal-lived projects.
If the projects are independent, the length of the
project lives is not critical.
But when unequal-lived projects are mutually
exclusive, the impact of differing lives must be
considered because the projects do not provide
service over comparable time periods.

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Capital Budgeting Refinements: Comparing
Projects With Unequal Lives (cont.)
The AT Company, a regional cable-TV firm, is
evaluating two projects, X and Y. The projects cash
flows and resulting NPVs at a cost of capital of 10% is
given below.

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Capital Budgeting Refinements:
Comparing Projects With Unequal Lives
(cont.)

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Capital Budgeting Refinements:
Comparing Projects With Unequal Lives
(cont.)

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Capital Budgeting Refinements:
Comparing Projects With Unequal Lives
(cont.)
Ignoring the difference in their useful lives, both
projects are acceptable (have positive NPVs).
Furthermore, if the projects were mutually exclusive,
project Y would be preferred over project X. However,
it is important to recognize that at the end of its 3
year life, project Y must be replaced, or renewed.

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Capital Budgeting Refinements:
Comparing Projects With Unequal Lives
(cont.)
The annualized net present value (ANPV)
approach is an approach to evaluating unequal-lived
projects that converts the net present value of unequal-
lived, mutually exclusive projects into an equivalent
annual amount (in NPV terms).
Step 1 Calculate the net present value of each
project j, NPVj, over its life, nj, using the
appropriate cost of capital, r.
Step 2 Convert the NPVj into an annuity having life
nj. That is, find an annuity that has the same
life and the same NPV as the project.
Step 3 Select the project that has the highest ANPV.

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Capital Budgeting Refinements:
Comparing Projects With Unequal Lives
(cont.)
By using the AT Company data presented earlier for
projects X and Y, we can apply the three-step ANPV
approach as follows:
Step 1 The net present values of projects X and Y
discounted at 10%as calculated in the preceding
example for a single purchase of each assetare
NPVX = $11,277.24
NPVY = $19,013.27

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Capital Budgeting Refinements:
Comparing Projects With Unequal Lives
(cont.)
Step 2 In this step, we want to convert the NPVs from
Step 1 into annuities. For project X, we are trying
to find the answer to the question, what 3-year
annuity (equal to the life of project X) has a
present value of $11,277.24 (the NPV of project
X)? Likewise, for project Y we want to know what
6-year annuity has a present value of $19,013.27.
Once we have these values, we can determine
which project, X or Y, delivers a higher annual cash
flow on a present value basis.

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Capital Budgeting Refinements:
Comparing Projects With Unequal Lives
(cont.)

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Capital Budgeting Refinements:
Comparing Projects With Unequal Lives
(cont.)

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Capital Budgeting Refinements:
Comparing Projects With Unequal Lives
(cont.)
Step 3 Reviewing the ANPVs calculated in Step 2, we can
see that project X would be preferred over project
Y. Given that projects X and Y are mutually
exclusive, project X would be the recommended
project because it provides the higher annualized
net present value.

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Recognizing Real Options

Real options are opportunities that are embedded in

capital projects that enable managers to alter their
cash flows and risk in a way that affects project
acceptability (NPV).
Also called strategic options.
By explicitly recognizing these options when making
capital budgeting decisions, managers can make
improved, more strategic decisions that consider in
advance the economic impact of certain contingent
actions on project cash flow and risk.
NPVstrategic = NPVtraditional + Value of real options

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Table 12.4
Major Types of Real Options

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Recognizing Real Options (cont.)

Assume that a strategic analysis of Bennett

Companys projects A and B finds no real options
embedded in Project A but two real options embedded
in B:
1. During its first two years, B would have downtime that
results in unused production capacity that could be used
to perform contract manufacturing;
2. Project Bs computerized control system could control two
other machines, thereby reducing labor costs.

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Recognizing Real Options (cont.)

Bennetts management estimated the NPV of the

contract manufacturing over the two years following
implementation of project B to be $1,500 and the NPV
of the computer control sharing to be $2,000.
Management felt there was a 60% chance that the
contract manufacturing option would be exercised and
only a 30% chance that the computer control sharing
option would be exercised. The combined value of
these two real options would be the sum of their
expected values.
Value of real options for project B
= (0.60 $1,500) + (0.30 $2,000)
= $900 + $600 = $1,500

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Recognizing Real Options (cont.)

Adding the $1,500 real options value to the traditional

NPV of $10,924 for project B, we get the strategic
NPV for project B.
NPVstrategic = $10,924 + $1,500 = $12,424
Bennett Companys project B therefore has a strategic
NPV of $12,424, which is above its traditional NPV
and now exceeds project As NPV of $11,071. Clearly,
recognition of project Bs real options improved its
NPV (from $10,924 to $12,424) and causes it to be
preferred over project A (NPV of $12,424 for B > NPV
of $11,071 for A), which has no real options
embedded in it.

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Capital Rationing

Firms often operate under conditions of capital

rationingthey have more acceptable independent
projects than they can fund.
In theory, capital rationing should not existfirms
should accept all projects that have positive NPVs.
However, in practice, most firms operate under
capital rationing.
Generally, firms attempt to isolate and select the
best acceptable projects subject to a capital
expenditure budget set by management.

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Capital Rationing (cont.)

The internal rate of return approach is an

approach to capital rationing that involves graphing
project IRRs in descending order against the total
dollar investment to determine the group of
acceptable projects.
The graph that plots project IRRs in descending
order against the total dollar investment is called
the investment opportunities schedule (IOS).
The problem with this technique is that it does not
guarantee the maximum dollar return to the firm.

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Capital Rationing (cont.)

Tate Company, a fast growing plastics company with a

cost of capital of 10%, is confronted with six projects
competing for its fixed budget of $250,000.

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Figure 12.4 Investment Opportunities
Schedule

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Capital Rationing (cont.)

According to the schedule, only projects B, C, and E

should be accepted. Together, they will absorb
$230,000 of the $250,000 budget. Projects A and F
are acceptable but cannot be chosen because of the
budget constraint. Project D is not worthy of
consideration because its IRR is less than the firms
10% cost of capital.

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Capital Rationing (cont.)

The net present value approach is an approach

to capital rationing that is based on the use of
present values to determine the group of projects
that will maximize owners wealth.
It is implemented by ranking projects on the basis
of IRRs and then evaluating the present value of
the benefits from each potential project to
determine the combination of projects with the
highest overall present value.

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Table 12.5 Rankings for Tate Company
Projects

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Capital Rationing (cont.)

Projects B, C, and E together yield a present value of $336,000.

However, if projects B, C, and A were implemented, the total
budget of $250,000 would be used and the present value of the
cash flows would be $357,000.
Implementing B, C, and A is preferable because they maximize
the present value for the given budget. The firms objective is to
use its budget to generate the highest present value of inflows.

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Review of Learning Goals

LG1 Understand the importance of recognizing risk

in the analysis of capital budgeting projects.
The cash flows associated with capital budgeting
projects typically have different levels of risk, and the
acceptance of a project generally affects the firms
overall risk. Thus it is important to incorporate risk
considerations in capital budgeting. Various behavioral
approaches can be used to get a feel for the level of
project risk. Other approaches explicitly recognize
project risk in the analysis of capital budgeting
projects.

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Review of Learning Goals (cont.)

LG2 Discuss risk and cash inflows, scenario analysis,

and simulation as behavioral approaches for
dealing with risk.
Risk in capital budgeting is the degree of variability of
cash flows, which for conventional capital budgeting
projects stems almost entirely from net cash flows.
Finding the breakeven cash inflow and estimating the
probability that it will be realized make up one
behavioral approach for assessing capital budgeting
risk. Scenario analysis is another behavioral approach
for capturing the variability of cash inflows and NPVs.
Simulation is a statistically based approach that
results in a probability distribution of project returns.

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Review of Learning Goals (cont.)

LG3 Review the unique risks that multinational

companies face.
Although the basic capital budgeting techniques are
the same for multinational and purely domestic
companies, firms that operate in several countries
must also deal with exchange rate and political risks,
tax law differences, transfer pricing, and strategic
issues.

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Review of Learning Goals (cont.)

LG4 Describe the determination and use of risk-

adjusted discount rates (RADRs), portfolio
effects, and the practical aspects of RADRs.
The risk of a project whose initial investment is known
with certainty is embodied in the present value of its
cash inflows, using NPV. Two opportunities to adjust
the present value of cash inflows for risk existadjust
the cash inflows or adjust the discount rate. Because
adjusting the cash inflows is highly subjective,
adjusting discount rates is more popular. RADRs use a
market-based adjustment of the discount rate to
calculate NPV.

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Review of Learning Goals (cont.)

LG5 Select the best of a group of unequal-lived,

mutually exclusive projects using annualized net
present values (ANPVs).
The ANPV approach is the most efficient method of
comparing ongoing, mutually exclusive projects that
have unequal usable lives. It converts the NPV of each
unequal-lived project into an equivalent annual
amount, its ANPV. The ANPV can be calculated using
equations, a financial calculator, or a spreadsheet. The
project with the highest ANPV is the best.

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Review of Learning Goals (cont.)

LG6 Explain the role of real options and the objective

and procedures for selecting projects under
capital rationing.
Real options are opportunities that are embedded in capital
projects and that allow managers to alter their cash flow and
risk in a way that affects project acceptability (NPV). By
explicitly recognizing real options, the financial manager can
find a projects strategic NPV.
Capital rationing exists when firms have more acceptable
independent projects than they can fund. The two basic
approaches for choosing projects under capital rationing are
the internal rate of return approach and the net present
value approach. The NPV approach better achieves the
objective of using the budget to generate the highest
present value of inflows.

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