RISK ANALYSIS IN CAPITAL BUDGETING

Risk analysis is important in making capital investment decisions because of the large amount of capital involved and the long-term nature of the investments being considered. The higher the risk associated with a proposed project, the greater the rate of return that must be earned on the project to compensate for that risk. Since different investment projects involve different risks, it is important to incorporate risk into the analysis of capital budgeting. There are several methods for incorporating risk, including: Probability distributions. 1. Risk adjusted discount rate. 2. Certainty equivalent. 3. Simulation. 4. Sensitivity analysis. 5. Decision trees (or probability trees). 6. PROBABILITY DISTRIBUTIONS Expected values of a probability distribution may be computed. Before any capital budgeting method is applied, compute the expected cash inflows, or in some cases, the expected life of the asset. EXAMPLE 5 A firm is considering a $30,000 investment in equipment that will generate cash savings from operating costs. The following estimates regarding cash savings and useful life, along with their respective probabilities of occurrence, have been made: Annual Cash Savings $6,000 $8,000 $10,000 Then, the expected annual saving is: Probability 0.2 0.5 0.3 Useful Life 4 years 5 years 6 years Probability 0.2 0.6 0.2

$6,000 (0.2) = $1,200 $8,000 (0.5) = $10,000 (0.3) = 4,000 3,000 $8,200 The expected useful life is: 4 (0.2) = 5 (0.6) = 6 (0.2) = 0.8 3.0 1.2 5 years The expected NPV is computed as follows (assuming a 10 percent cost of capital): NPV = PV - I = $8,200 T4(10%,5) - $30,000 = $8,200 (3.7908) - $30,000 = $31,085 - 30,000 = $1,085 The expected IRR is computed as follows: By definition, at IRR, I = PV $30,000 = $8,200 T4 (r,5)

which is about halfway between 10 percent and 12 percent in Table 4 in the Appendix, so that we can estimate the rate to be about 11 percent. Therefore, the equipment should be purchased, since (1) NPV = $1,085, which is positive, and/or (2) IRR = 11 percent, which is greater than the cost of capital of 10 percent. RISK ADJUSTED DISCOUNT RATE This method of risk analysis adjusts the cost of capital (or discount rate) upward as projects become riskier, i.e., a risk-adjusted discount rate is the riskless rate plus a risk premium. Therefore, by increasing the discount rate from 10 percent to 15 percent, the expected cash flow from the investment must be relatively larger or the increased discount rate will generate a

negative NPV, and the proposed acquisition/investment would be turned down. The expected cash flows are discounted at the risk-djusted discount rate and then the usual capital budgeting criteria such as NPV and IRR are applied. NOTE: The use of the risk-adjusted discount rate is based on the assumption that investors demand higher returns for riskier projects. EXAMPLE 6 A firm is considering an investment project with an expected life of 3 years. It requires an initial investment of The firm estimates the following data in each of the next 4 $35,000. years: After Tax Cash Inflow $5,000 $10,000 $30,000 $50,000 Probability 0.2 0.3 0.3 0.2

Assuming a risk-adjusted required rate of return (after taxes) of 20 percent is appropriate for the investment projects of this level or risk, compute the risk adjusted NPV. First, the present value is: PV= - $5,000(0.2) + $10,000(0.3) + $30,000(0.3) + $50,000(0.2)=$21,000 The expected NPV = $21,000 T4(20%,3) - $35,000 = 21,000 (2,107) - $35,000 = $44,247 $35,000 = $9,247 CERTAINTY EQUIVALENT APPROACH The certainty equivalent approach to risk analysis is to convert cash flows from individual projects into risk adjusted certainty equivalent cash flows. The approach is drawn directly from the concept of utility theory. This method forces the decision maker to specify at what point the firm is indifferent to the choice between a certain sum of money and the expected value of a risky sum. Under this approach, first determine a certainty equivalent adjustment factor, , as:

Once `s are obtained, they are multiplied by the original cash flow to obtain the equivalent certain cash flow. Then, the accept-or-reject decision is made, using the normal capital budgeting criteria. The risk-free rate of return is used as the discount rate under the NPV method and as the cutoff rate under the IRR method. EXAMPLE 7 XYZ, Inc., with a 14 percent cost of capital after taxes is considering a project with an expected life of 4 years. The The project requires an initial certain cash outlay of $50,000. expected cash inflows and certainty equivalent coefficients are as follows: Year 1 2 3 4 After Tax Cash Flow $10,000 15,000 20,000 25,000 Certainty Equivalent Adjustment Factor 0.95 0.80 0.70 0.60

Assuming that the risk-free rate of return is 5 percent, the NPV and IRR are computed as follows:

NPV = $44,366 $50,000 = $5,634 By trial and error, we obtain 4 percent as the IRR. Therefore, the project should be rejected, since (1) NPV = $5,634, which is negative and/or (2) IRR = 4 percent is less than the risk-free rate of 5 percent. SIMULATION This risk analysis method is frequently called Monte Carlo simulation. It requires that a probability distribution be constructed for each of the important variables affecting the project`s cash flows. Since a computer is used to generate many results using random numbers, project simulation is expensive. SENSITIVITY ANALYSIS

Forecasts of many calculated NPVs under various alternative functions are compared to see how sensitive NPV is to changing conditions. It may be found that a certain variable or group of variables, once their assumptions are changed or relaxed, drastically alters the NPV. This results in a much riskier asset than was originally forecast. DECISION TREES Some firms use decision trees (probability trees) to evaluate the risk of capital budgeting proposals. A decision tree is a graphical method of showing the sequence of possible outcomes. A capital budgeting tree would show the cash flows and NPV of the project under different possible circumstances. The decision tree method has the following advantages: (1) It visually lays out all the possible outcomes of the proposed project and makes management aware of the adverse possibilities, and (2) the conditional nature of successive years` cash flows can be expressly depicted. The disadvantages are: (1) most problems are too complex to permit year-byyear depiction and (2) it does not recognize risk. Note: In a decision tree, the events following from a decision are mutually exclusive. Also, all possible events are included. Thus, the sum of the probabilities of the events is 1.0. EXAMPLE 8 Assume XYZ Corporation wishes to introduce one of two products to the market this year. The probabilities and present values (PV) of projected cash inflows are given below: Product A Initial investment $225,000 $450,000 200,000 100,000 B 80,000 320,000 100,000 150,000 A decision tree analyzing the two products is given in Figure 2. FIGURE 2 PV of cash inflows Proba bilities 1.00 0.40 0.50 0.10 1.00 0.20 0.60 0.20

Based on the expected NPV, choose product A over product B. This analysis fails to recognize the risk factor in project analysis.