chapter 12 risk and refinements on cb - tmc...
Post on 07-Feb-2018
224 Views
Preview:
TRANSCRIPT
© 2012 Pearson Prentice Hall. All rights reserved. 12-2
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 firm’s overall risk.
• In actuality, these situations are rare—projects are not
equally risky, and the acceptance of a project can affect
the firm’s overall risk.
© 2012 Pearson Prentice Hall. All rights reserved. 12-3
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.
© 2012 Pearson Prentice Hall. All rights reserved. 12-4
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.
© 2012 Pearson Prentice Hall. All rights reserved. 12-5
Table 12.2 Scenario Analysis of
Treadwell’s Projects A and B
© 2012 Pearson Prentice Hall. All rights reserved. 12-7
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.
The Monte Carlo Method: The Forecast Is for Less Uncertainty
– To combat uncertainty in the decision-making process, some companies use a Monte Carlo simulation program to model possible outcomes.
– A Monte Carlo simulation program randomly generates values for uncertain variables over and over to simulate a model.
– One of the problems with using a Monte Carlo program is the difficulty of establishing the correct input ranges for the variables and determining the correlation coefficients for those variables.
© 2012 Pearson Prentice Hall. All rights reserved. 12-8
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 project’s cash flows are denominated will reduce the market value of that project’s cash flow.
– In the short term, much of this risk can be hedged
– Long-term exchange rate risk can best be minimized by financing the project in whole or in part in the local currency.
• Political risk is much harder to protect against.
– Governments can seize the firm’s assets, or otherwise interfere with a
project’s operation.
– They can do so either by adjusting a project’s expected cash inflows to
account for the probability of political interference or by using risk-adjusted
discount rates in capital budgeting formulas.
© 2012 Pearson Prentice Hall. All rights reserved. 12-9
Risk-Adjusted Discount Rates
Risk-adjusted discount rates (RADR) are rates of return
that must be earned on a given project to compensate the
firm’s owners adequately—that is, to maintain or improve
the firm’s share price.
The higher the risk of a project, the higher the RADR—and
thus the lower a project’s NPV.
© 2012 Pearson Prentice Hall. All rights reserved. 12-10
Risk-Adjusted Discount Rates:
Review of CAPM
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 project j
rm = return on the market portfolio of assets
© 2012 Pearson Prentice Hall. All rights reserved. 12-12
How do we get the RADR
• Managers can characterize projects by
– Risk indexes
– Risk classes
• How this is done varies
– Could be subjective
– Could be statistical
• Lets say a CV > 2.7 = risk class 4 or risk index 7
© 2012 Pearson Prentice Hall. All rights reserved. 12-13
Risk-Adjusted Discount Rates:
Applying RADRs (cont.)
© 2012 Pearson Prentice Hall. All rights reserved. 12-14
Table 12.3 Bennett Company’s
Risk Classes and RADRs
© 2012 Pearson Prentice Hall. All rights reserved. 12-15
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.
© 2012 Pearson Prentice Hall. All rights reserved. 12-16
Capital Budgeting Refinements:
Comparing Projects With Unequal Lives
• But when unequal-lived projects are mutually
exclusive, the impact of differing lives must be
considered because they do not provide service
over comparable time periods.
– This is particularly important when continuing service is
needed from the projects under consideration.
© 2012 Pearson Prentice Hall. All rights reserved. 12-17
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.
Project X Project Y
Year
0 (70,000)$ (85,000)$
1 28,000$ 35,000$
2 33,000$ 30,000$
3 38,000$ 25,000$
4 -$ 20,000$
5 -$ 15,000$
6 -$ 10,000$
NPV $11,277 $19,013
Cash Flows
© 2012 Pearson Prentice Hall. All rights reserved. 12-18
Annualized NPV (ANPV)
Capital Budgeting Refinements: Comparing
Projects With Unequal Lives (cont.)
CB: Unequal Lives
© 2012 Pearson Prentice Hall. All rights reserved. 12-19
Capital Rationing
• Firm’s often operate under conditions of capital rationing—they have more acceptable independent projects than they can fund.
• In theory, capital rationing should not exist—firms 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.
http://www.youtube.com/watch?feature=player_detailpage&v=qOjLLRFsp1I
© 2012 Pearson Prentice Hall. All rights reserved. 12-20
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.
© 2012 Pearson Prentice Hall. All rights reserved. 12-21
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 $250,000.
Project Initial Investment IRR PV of Inflows NPV
A 80,000$ 12% 100,000$ 20,000$
B 70,000 20% 112,000 42,000
C 100,000 16% 145,000 45,000
D 40,000 8% 36,000 (4,000)
E 60,000 15% 79,000 19,000
F 110,000 11% 126,500 16,500
© 2012 Pearson Prentice Hall. All rights reserved. 12-22
IRR Approach Assume the firm’s
cost of capital
is 10% and has
a maximum of
$250,000 available
for investment.
Ranking the
projects according
to IRR, the
optimal set of
projects for
Tate is B, C,
and E,
However project A and F are
acceptable project!s! They have an
IRR greater than the cost of capital!!
CB: Capital Rationing
© 2012 Pearson Prentice Hall. All rights reserved. 12-23
Figure 12.4 Investment
Opportunities Schedule
© 2012 Pearson Prentice Hall. All rights reserved. 12-24
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.
© 2012 Pearson Prentice Hall. All rights reserved. 12-25
NPV Approach Now we will rank by NPV.
With the $250,000 limit in
investment we will only do
projects C, B, and A
While projects E & F clearly
will add wealth to the
shareholder.
Why?
CB: Capital Rationing
Cost of Capital and Investing
© 2012 Pearson Prentice Hall. All rights reserved. 10-26
Part 1
http://www.youtube.com/watch?feature=player_detailp
age&v=PDA1F6e5mW4
Part 2
http://www.youtube.com/watch?feature=player_detailp
age&v=X4uPRQTKqTA
Part 3
http://www.youtube.com/watch?feature=player_detailp
age&v=aH5S8e19Cn4
Part 4
http://www.youtube.com/watch?feature=player_detailp
age&v=aH5S8e19Cn4
top related