13 Risk and Capital Budgeting Prepared by Michel

Chapter 13 - Outline • • Definition of Risk Concept of Risk Aversion Statistical Measurements of Risk Methods Dealing with Risk in the Capital Budgeting Process • Portfolio Effect • Summary and Conclusions 2 of 27 © 2009 Mc. Graw-Hill Ryerson Limited

Learning Objectives 1. Describe the concept of risk based on the uncertainty of future cash flows. (LO 1) 2. Define risk as standard deviation, coefficient of variation or beta. (LO 2) 3. Describe most investors as risk-averse. (LO 3) 4. Utilize the basic methodology of risk-adjusted discount rates for dealing with risk in capital budgeting analysis. (LO 4) 3 of 27 © 2009 Mc. Graw-Hill Ryerson Limited

Learning Objectives 5. Describe and apply the techniques of certainty equivalents, simulation models, sensitivity analysis and decision trees to help assess risk. (LO 5) 6. Discuss how a project’s risk may be considered in a portfolio context. (LO 6) 4 of 27 © 2009 Mc. Graw-Hill Ryerson Limited

LO 1 Definition of Risk • Risk may be defined in terms of the variability of possible outcomes from a given investment. - The return on an investment in T-bills is certain, that is, there is no variability, therefore, has no risk. - The return on an investment in a gold-mining expedition in Borneo is not certain, as the variability of possible outcomes is great, thus carry a greater risk. • Please note that risk is measured not only in terms of loss but also uncertainty. • Which of the following 3 investments in Figure 13 -1 has the highest risk? 5 of 27 © 2009 Mc. Graw-Hill Ryerson Limited

LO 1 FIGURE 13 -1 Variability and risk 6 of 27 © 2009 Mc.

LO 1/LO 3 Concept of Risk Aversion • Investment “C” has the highest risk! • Risk aversion means avoiding risk, that is, for a given situation, people would prefer relative certainty to uncertainty. • This does not say that people are unwilling to take risks but rather that they require a higher expected return for risky investments. 7 of 27 © 2009 Mc. Graw-Hill Ryerson Limited

LO 2 Statistical Measurements of Risk Expected Value: – equals the weighted average of possible outcomes (forecasts) times their probabilities – gives you the most likely forecast / your best estimate Standard Deviation: – measure of dispersion or variability around the expected value – gives you a measure of the spread of possible outcomes – larger the standard deviation greater the risk Coefficient of Variation: – equal to standard deviation / expected value – allows you to compare investments of different sizes – larger the coefficient of variation greater the risk 8 of 27 © 2009 Mc. Graw-Hill Ryerson Limited

LO 2 FIGURE 13 -3 Probability distribution with differing degrees of risk 9 of

LO 2 Which Investment is the Riskiest? • As these investments have the same expected value of $600, the standard deviation is a good measure of risk. • The investment with the highest standard deviation would be considered the riskiest. • If we compare two investments with quite different expected values, the coefficient of variation is a more accurate measure of risk. 10 of 27 © 2009 Mc. Graw-Hill Ryerson Limited

LO 2 a statistical measure of volatility (risk) – It measures how responsive or sensitive a company’s stock is to market movements in general An individual stock’s beta shows how risky it compares to the market as a whole: – beta = 1 means equal risk with the market – beta > 1 means more risky than the market – beta < 1 means less risky than the market Company risk may provide guideline to risk of a new investment in that company 11 of 27 © 2009 Mc. Graw-Hill Ryerson Limited

LO 2 Table 13 -2 Betas, October 2008 Company Name Beta Bombardier (BBD). . . . Canadian Tire (CTC). . . . Power Corp. (POW). . . . Potash (POT). . . . . RIM (RIM). . . . . Royal Bank (RY). . . . 1. 52 0. 37 0. 55 1. 84 2. 16 0. 88 Source: www. reuters. com/finance/stocks http: //pages. stern. nyu. edu/~adamovar/New_Home_Page/data. html 12 of 27 © 2009 Mc. Graw-Hill Ryerson Limited

Methods Dealing with Risk in the Capital Budgeting Process LO 4 1. adjusting the discount rate to reflect the risk level associated with an investment proposal 2. converting cash flows to their certainty equivalents 3. simulating various economic and financial outcomes with the help of a computer 4. testing the sensitivity of a project’s success to some key variables 5. using a decision tree 13 of 27 © 2009 Mc. Graw-Hill Ryerson Limited

LO 4 FIGURE 13 -5 Relationship of risk to discount rate 14 of 27

LO 4 TABLE 13 -3 Risk classes and associated discount rates 15 of 27

LO 4 Table 13 -4 Capital Budgeting Analysis Investment A Year (10% discount rate) Investment B (10% discount rate) Year P. V. 1 2 3 P. V. $5, 000 $1, 364 5, 000 1, 653 2, 000 1, 878 $4, 545 1 $1, 500 4, 132 2 2, 000 1, 503 3 2, 500 $10, 180 4 5, 000 5 5, 000 3, 415 3, 105 $11, 415 16 of 27 Present value of inflows $ 10, 180 Present value of inflows $11, 415 © 2009 Mc. Graw-Hill Ryerson Limited

LO 4 Table 13 -5 Capital budgeting decision adjusted for risk Investment A Year (10% discount rate) 1 2 3 Year $5, 000 $1, 250 5, 000 1, 389 2, 000 1, 447 Investment B (20% discount rate) $4, 545 1 $1, 500 4, 132 2 2, 000 1, 503 3 2, 500 $10, 180 4 5, 000 2, 411 5 5, 000 2, 009 $ 8, 506 17 of 27 Present value of inflows Investment $10, 180 Present value of inflows $ 8, 506 10, 000 Investment © 2009 Mc. Graw-Hill Ryerson Limited

LO 5 Certainty Equivalents 18 of 27 © 2009 Mc. Graw-Hill Ryerson Limited

LO 5 FIGURE 13 -7 Simulation flow chart 19 of 27 © 2009 Mc.

LO 5 FIGURE 13 -8 Decision trees 20 of 27 © 2009 Mc. Graw-Hill

LO 6 Portfolio Effect • In capital budgeting, merely considering the risk inherent in an individual investment proposal is not enough. • The impact of a given investment on the overall risk of the firm – the portfolio effect should also be taken into account. • Whether a given investment changes a firm’s overall risk depends on its relationship to other investments. 21 of 27 © 2009 Mc. Graw-Hill Ryerson Limited

LO 6 22 of 27 © 2009 Mc. Graw-Hill Ryerson Limited

LO 6 Measures of Correlation • Coefficient of correlation shows the extent of correlation among projects • Has a numerical value of between -1 and +1 • Its value shows the risk reduction between projects: – Negative correlation (-1) Large risk reduction – No correlation (0) Some risk reduction – Positive correlation (+1) No risk reduction Coefficient of Correlation Coefficient of Variation 23 of 27 © 2009 Mc. Graw-Hill Ryerson Limited

LO 6 TABLE 13 -7 Rates of return for Conglomerate, Inc. , and two

LO 6 The Efficient Frontier Firm chooses combinations of projects with the best trade-off between risk and return 2 objectives of management: 1. Achieve the highest possible return at a given risk level 2. Provide the lowest possible risk at a given return level The Efficient Frontier is the best risk-return line or combination of possibilities Firm must decide where to be on the line (there is no “right” answer) 25 of 27 © 2009 Mc. Graw-Hill Ryerson Limited

LO 6 FIGURE 13 -11 Risk-return tradeoffs 26 of 27 © 2009 Mc. Graw-Hill

Summary and Conclusions • Risk may be defined as the variability or uncertainty of the potential outcomes from an investment. • Investors and managers tend to be risk averse. • Standard deviation, coefficient of variation and beta are statistical measures of risk. • The methods dealing with risk in the capital budgeting process include adjusting the discount rate, calculating certainty equivalents, simulating, analyzing sensitivity and using a decision tree. • Management must consider not only the individual project’s risk, but also the portfolio effect. 27 of 27 © 2009 Mc. Graw-Hill Ryerson Limited