Lecture 4: Risk and Refinements in Capital Budgeting Flashcards
What is the function of behavioral approaches?
To get a “feel” for a project’s risk, whereas other approaches try to quantify & measure the project’s risk.
What are the behavioral approaches in dealing w/ risk in capital budgeting?
- Breakeven analysis
- Scenario analysis
- Simulation
Besides using the NPV method to decide how to invest the firm’s money, what is another important thing that CEOs said?
Their gut feel for a project was an important factor in their decision.
What are the functions of Breakeven analysis?
1) Risk in capital budgeting
The uncertainty surrounding the cash flows that a project will generate or the degree of variability of cash flows. To assess risk of proposed capital expenditures, analyst must evaluate the probability that cash inflows will be large enough to produce a +ve NPV.
2) Breakeven cash flow
The min. level of cash inflows necessary for a project to be acceptable. (NPV > 0)
For break-even analysis, what happens after we found the breakeven cash infow aka ordinary annuity (PMT)?
Then that figure / amount indicates that for a project to be accepted, they must have annual cash inflows of not less than that figure that we’ve computed.
Scenario analysis
It is a behavioral approach that uses several possible alternative outcomes to obtain a sense of variability of returns, measured by the NPV.
This technique is often useful in getting a feel for the variability of return in response to changes in a key outcome.
Eg: estimate NPVs associated w/ pessimistic, most likely and optimistic estimates of cash flows.
In scenario analysis, how do we determine if the project is more risky or less risky?
Three scenarios will normally be compared: pessimistic, most likely and optimistic.
From the results obtained, we’ll look at the range of annual cash inflows and range of NPV. The larger the figure of this range aka variability, the more risky is the project. Therefore, we should choose the project w/ smaller ranges which indicates less risk. However, note that we should not accept those w/ -ve NPV as well as there is a possibility of loss.
Simulation
It is a statistics-based behavioral approach that applies predetermined probability distributions & random numbers to estimate risky outcomes.
From distribution of returns, decision maker can determine not only the expected value of return but also the probability of achieving or surpassing a given return.
Output of simulation is an excellent basis for decision making because it enables the decision maker to view a continum of risk-return tradeoffs rather than just a single-point estimate.
What are the 2 types of international risks?
- Exchange rate risks: the danger that an unexpected change in the exchange rate between dollar and the currency in which project’s cash flows are denominated will reduce the market value of that project’s cash flow.
- Political risks: arises from the possibility that a host gov will take actions harmful to foreign investors or that political turmoil will endanger investments.
What are some of the special issues that are relevant only for international capital budgeting?
- Taxes
- assess the impact of tax payments on parent company’s tax liability
- check if there’s tax treaties
- carefully account for taxes paid to foreign gov on profits earned within their borders since only after-tax cash flows are relevant for capital budgeting. - Transfer Pricing
- prices that subsidiaries charge each other for the goods & services traded between them
- shipment of goods and services from one of a parent co.’s subsidiaries to another subsidiary located abroad
- parent co. has some discretion in setting transfer prices, the prices that subsidiaries charge each other for the goods & services traded between them
Note: The use of transfer pricing in international trade makes capital budgeting in MNCs very difficult unless the transfer prices that are used accurately reflect the actual costs & incremental cash flows.
What are the 2 opportunities to adjust the PV of cash inflows for risk:
- The cash inflows can be adjusted.
- The discount rate can be adjusted.
In conclusion, we consider the portfolio effects of a project analysis as well as the practical aspects of the RADR
Risk Adjusted Discount Rates (RADR)
The rate of return that must be earned on a given project to compensate the firm’s oweners adequately, that is to maintain or improve the firm’s share price.
Is it true that when there is higher risk, there’ll be higher NPV?
Yes
What is the formula for CAPM in computing the risk adjusted discount rates (RADRs)?
Total risks = Nondiversifiable risk (systematic risk) + Diversifiable risk (unsystematic risk)
r = Rf + (Rm-Rf)ß
Any project having an IRR above the SML would be acceptable. Is this true?
Yes, because its IRR would exceed the required return. Any project with an IRR below the return of project would be rejected.
In terms of NPV, any project falling above the SML would have a positive NPV. Any project falling below the SML would have a negative NPV. Is this true?
Yes.
What happens when IRR is greater than the required return?
This indicates that NPV is +ve, hence the project should be accepted.
What does CAPM assumes?
CAPM is based on an assumed efficient market, which does not always exist for real corporate assets.
How do most firms determine the risk adjusted discount rate?
By adjusting their exisitng required return.
What is the function of risk indexes?
It is merely a numerical scale used to classify project risk. Normally projects w/ higher risk are assigned higher risk index value.
When risk index increases, its required return increases too. Is this true?
Yes.
What are portfolio effects?
It says the investors are not rewarded for taking diversifiable risk, therefore they should hold a diversified portfolio of securities to eliminate that risk.
Is it important that the firm maintain a diversified portfolio of asset?
If they are, the value of firm could be enhanced through diversification into other lines of business. However, the value of the stock of firms whose shares are traded publicly in an efficient marketplace is generally not affected by diversification.
Why are firms not rewarded for diversification?
- investors themselves can diversify by holding securities in a variety of firms, they do not need the firm to do it for them
- the use of total risk as an approximation for the relevant risk has widespread practical appeal
