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Chapter 11 - Capital Budgeting
and Risk Analysis
2005, Pearson Prentice Hall
Three Measures of a Projects Risk
Project Standing
Alone Risk
Risk
diversified away
within firm as this
project is combined
with firms other
projects and assets.
Risk
diversified away
by shareholders as
securities are combined
to form diversified
portfolio.
Projects
Contribution-
to-Firm Risk
Systematic Risk
Incorporating Risk into
Capital Budgeting
Two Methods:
Certainty Equivalent Approach
Risk-Adjusted Discount Rate
How can we adjust this model to
take risk into account?
Adjust the After-tax Cash Flows (ACFs),
or
Adjust the discount rate (k).
NPV = - IO
FCFt
(1 + k)
t
n
t=1

Certainty Equivalent Approach
Adjusts the risky after-tax cash flows
to certain cash flows.
The idea:
Risky Certainty Certain
Cash X Equivalent = Cash
Flow Factor (a) Flow
Certainty Equivalent Approach
Risky Certainty Certain
Cash X Equivalent = Cash
Flow Factor (a) Flow
Risky safe
P 1,000.00 .70 P 700.00
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Certainty Equivalent Approach
Risky Certainty Certain
Cash X Equivalent = Cash
Flow Factor (a) Flow
Risky safe
P 1,000.00 .95 P 950.00
The greater the risk associated
with a particular cash flow,
the smaller the CE factor.
Certainty Equivalent Method
t
NPV = - IO
t ACFt
(1 + krf)
n
t=1

Certainty Equivalent Approach
Steps:
1) Adjust all after-tax cash flows by
certainty equivalent factors to get
certain cash flows.
2) Discount the certain cash flows by
the risk-free rate of interest.
Incorporating Risk into
Capital Budgeting
Risk-Adjusted Discount Rate
How can we adjust this model
to take risk into account?
Adjust the discount rate (k).
NPV = - IO
ACFt
(1 + k)
t
n
t=1

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Risk-Adjusted Discount Rate
Simply adjust the discount rate (k)
to reflect higher risk.
Riskier projects will use higher
risk-adjusted discount rates.
Calculate NPV using the new risk-
adjusted discount rate.
Risk-Adjusted Discount Rate
NPV = - IO
FCFt
(1 + k*)
t
n
t=1

Risk-Adjusted Discount Rates
How do we determine the
appropriate risk-adjusted discount
rate (k*) to use?
Many firms set up risk classes to
categorize different types of
projects.
Risk Classes
Risk RADR
Class (k*) Project Type
1 12% Replace equipment,
Expand current business
2 14% Related new products
3 16% Unrelated new products
4 24% Research & Development
Summary: Risk and
Capital Budgeting
You can adjust your capital budgeting
methods for projects having different levels
of risk by:
Adjusting the discount rate used (risk-
adjusted discount rate method),
Measuring the projects systematic risk,
Analyzing computer simulation methods,
Performing scenario analysis, and
Performing sensitivity analysis.