2009 McGraw-Hill Ryerson Limited 1 of Risk and Capital Budgeting Risk and Capital Budgeting Prepared by: Michel Paquet SAIT Polytechnic 2009 McGraw-Hill Ryerson Limited 2 of 27 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 2009 McGraw-Hill Ryerson Limited 3 of 27 Learning Objectives 1.Describe the concept of risk based on the uncertainty of future cash flows. (LO1) 2.Define risk as standard deviation, coefficient of variation or beta. (LO2) 3.Describe most investors as risk-averse. (LO3) 4.Utilize the basic methodology of risk-adjusted discount rates for dealing with risk in capital budgeting analysis. (LO4) 2009 McGraw-Hill Ryerson Limited 4 of 27 Learning Objectives 5.Describe and apply the techniques of certainty equivalents, simulation models, sensitivity analysis and decision trees to help assess risk. (LO5) 6.Discuss how a projects risk may be considered in a portfolio context. (LO6) 2009 McGraw-Hill Ryerson Limited 5 of 27 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? LO1 2009 McGraw-Hill Ryerson Limited 6 of 27 FIGURE 13-1 Variability and risk LO1 2009 McGraw-Hill Ryerson Limited 7 of 27 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. LO1/LO3 2009 McGraw-Hill Ryerson Limited 8 of 27 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 LO2 2009 McGraw-Hill Ryerson Limited 9 of 27 FIGURE 13-3 Probability distribution with differing degrees of risk LO2 2009 McGraw-Hill Ryerson Limited 10 of 27 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. LO2 2009 McGraw-Hill Ryerson Limited 11 of 27 a statistical measure of volatility (risk) It measures how responsive or sensitive a companys stock is to market movements in general An individual stocks 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 LO2 2009 McGraw-Hill Ryerson Limited 12 of 27 Table 13-2 Betas, October 2008 Company NameBeta Bombardier (BBD) Canadian Tire (CTC) Power Corp. (POW) Potash (POT) RIM (RIM) Royal Bank (RY) LO2 Source: 2009 McGraw-Hill Ryerson Limited 13 of 27 Methods Dealing with Risk in the Capital Budgeting Process 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 projects success to some key variables 5.using a decision tree LO4 2009 McGraw-Hill Ryerson Limited 14 of 27 FIGURE 13-5 Relationship of risk to discount rate LO4 2009 McGraw-Hill Ryerson Limited 15 of 27 TABLE 13-3 Risk classes and associated discount rates LO4 2009 McGraw-Hill Ryerson Limited 16 of 27 Table 13-4 Capital Budgeting Analysis Investment AInvestment B Year(10% discount rate)Year(10% discount rate) P.V. 1$5,000 $4,5451$1,500$1,364 25,000 4,13222,0001,653 32,000 1,50332,5001,878 $10,18045,0003,415 55,0003,105 $11,415 Present value of inflows$10,180Present value of inflows$11,415 Investment10,000Investment 10,000 Net present value$ 180Net present value$ 1,415 LO4 2009 McGraw-Hill Ryerson Limited 17 of 27 Table 13-5 Capital budgeting decision adjusted for risk Investment AInvestment B Year(10% discount rate)Year(20% discount rate) 1$5,000 $4,5451$1,500$1,250 25,000 4,13222,0001,389 32,000 1,50332,5001,447 $10,18045,0002,411 55,0002,009 $ 8,506 Present value of inflows$10,180Present value of inflows$ 8,506 Investment10,000Investment10,000 Net present value$ 180Net present value$ (1,494) LO4 2009 McGraw-Hill Ryerson Limited 18 of 27 Certainty Equivalents LO5 2009 McGraw-Hill Ryerson Limited 19 of 27 FIGURE 13-7 Simulation flow chart LO5 2009 McGraw-Hill Ryerson Limited 20 of 27 FIGURE 13-8 Decision trees LO5 2009 McGraw-Hill Ryerson Limited 21 of 27 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 firms overall risk depends on its relationship to other investments. LO6 2009 McGraw-Hill Ryerson Limited 22 of 27 LO6 2009 McGraw-Hill Ryerson Limited 23 of 27 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 LO6 2009 McGraw-Hill Ryerson Limited 24 of 27 TABLE 13-7 Rates of return for Conglomerate, Inc., and two merger candidates LO6 2009 McGraw-Hill Ryerson Limited 25 of 27 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) LO6 2009 McGraw-Hill Ryerson Limited 26 of 27 FIGURE Risk-return tradeoffs LO6 2009 McGraw-Hill Ryerson Limited 27 of 27 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 projects risk, but also the portfolio effect.