Chapter 12: Risk and refinements in capital budgeting
12.1 Introduction to risk in capital budgeting
In Ch 10 and 11 all projects were assumed to be equally risky
o I.e. al mutually exclusive projects were equally risky and the acceptance of any project would not
change the firm’s overall risk
In actuality, these situations are rare – project cash flows typically have different levels of risk and the
acceptance of a project does affect the firm’s overall risk (in a minor way)
12.2 Behavioural approaches for dealing with risk
Risks result from a variety of factors including uncertainty about future revenues, expenditure and taxes
Behavioural approaches can be used to get a ‘feel’ for the level of project risk
Risk and cash inflows
Risk (in capital budgeting): the chance that a project will prove unacceptable, i.e. the variability of cash flows,
uncertainty of cash flows that will be generated
Projects with a small chance of acceptability and a broad range of expected cash flows are riskier than
projects that have a high chance of acceptability and narrow range of expected cash flows
Risk stems almost entirely from cash flows (initial investment is generally known with certainty)
Number of variables: (we focus on cash flows)
o Level of sales
o Cost of raw material
o Labour rates
o Utility costs
o Tax rates
To assess the risk of a potential project, the analyst needs to evaluate the probability that the cash flows will
be large enough to provide the project acceptance
Breakeven cash inflow: minimum level of cash inflow necessary for a project to be acceptable, i.e. NPV > R0
o Pmt = minimum amount project must earn per year in order to risk even
PV = initial investment
i = cost of capital
n = project life
Pmt = ?
Risk can now be assessed by calculating the probability of the cash inflows to equal or exceed this breakeven
level
E.g. CFA > R Pmt = 100% probability vs CFB > R Pmt = 65% probability, choose project A – higher probability
of getting return
Scenario analysis
Scenario analysis is a behavioural approach similar to sensitivity analysis but scope is broader
Method evaluates the impact on the firm’s return of simultaneous changes in a number of variables such as
cash inflows, outflows and cost of capital
NPV is calculated under each different set of variable assumptions
Capture the variability of cash flows and NPVs
Most common scenario approach is to estimate the NPVs associated with pessimistic (worst), most likely
(expected) and optimistic (best) estimates of cash flow
, Range = optimistic – pessimistic
Smaller NPV range = less risky
(Page: 464)
NPV:
Simulation
Simulation – statistics-based behavioural approach that applies predetermined probability distributions and
random numbers to estimate risky outcomes
Computers made using simulation economically feasible
Financial manager develops a probability distribution of project returns
Simulation is an excellent basis for decision-making – enable decision-maker to view a continuum of risk-
return trade-offs rather than a single-point estimate
Probability of achieving a given return
12.3 International risk considerations
Multinational companies (MNC’s) face risks unique to their international area
Exchange rate risk – danger that unexpected change in the exchange rate between rand and currency in
which a project’s cash flows are denominated will reduce the market value of that project’s cash flow
o Risk unexpected change in exchange rate will reduce NPV of project’s cash flows
12.1 Introduction to risk in capital budgeting
In Ch 10 and 11 all projects were assumed to be equally risky
o I.e. al mutually exclusive projects were equally risky and the acceptance of any project would not
change the firm’s overall risk
In actuality, these situations are rare – project cash flows typically have different levels of risk and the
acceptance of a project does affect the firm’s overall risk (in a minor way)
12.2 Behavioural approaches for dealing with risk
Risks result from a variety of factors including uncertainty about future revenues, expenditure and taxes
Behavioural approaches can be used to get a ‘feel’ for the level of project risk
Risk and cash inflows
Risk (in capital budgeting): the chance that a project will prove unacceptable, i.e. the variability of cash flows,
uncertainty of cash flows that will be generated
Projects with a small chance of acceptability and a broad range of expected cash flows are riskier than
projects that have a high chance of acceptability and narrow range of expected cash flows
Risk stems almost entirely from cash flows (initial investment is generally known with certainty)
Number of variables: (we focus on cash flows)
o Level of sales
o Cost of raw material
o Labour rates
o Utility costs
o Tax rates
To assess the risk of a potential project, the analyst needs to evaluate the probability that the cash flows will
be large enough to provide the project acceptance
Breakeven cash inflow: minimum level of cash inflow necessary for a project to be acceptable, i.e. NPV > R0
o Pmt = minimum amount project must earn per year in order to risk even
PV = initial investment
i = cost of capital
n = project life
Pmt = ?
Risk can now be assessed by calculating the probability of the cash inflows to equal or exceed this breakeven
level
E.g. CFA > R Pmt = 100% probability vs CFB > R Pmt = 65% probability, choose project A – higher probability
of getting return
Scenario analysis
Scenario analysis is a behavioural approach similar to sensitivity analysis but scope is broader
Method evaluates the impact on the firm’s return of simultaneous changes in a number of variables such as
cash inflows, outflows and cost of capital
NPV is calculated under each different set of variable assumptions
Capture the variability of cash flows and NPVs
Most common scenario approach is to estimate the NPVs associated with pessimistic (worst), most likely
(expected) and optimistic (best) estimates of cash flow
, Range = optimistic – pessimistic
Smaller NPV range = less risky
(Page: 464)
NPV:
Simulation
Simulation – statistics-based behavioural approach that applies predetermined probability distributions and
random numbers to estimate risky outcomes
Computers made using simulation economically feasible
Financial manager develops a probability distribution of project returns
Simulation is an excellent basis for decision-making – enable decision-maker to view a continuum of risk-
return trade-offs rather than a single-point estimate
Probability of achieving a given return
12.3 International risk considerations
Multinational companies (MNC’s) face risks unique to their international area
Exchange rate risk – danger that unexpected change in the exchange rate between rand and currency in
which a project’s cash flows are denominated will reduce the market value of that project’s cash flow
o Risk unexpected change in exchange rate will reduce NPV of project’s cash flows
