Lecture 4: Risk and Refinements in Capital Budgeting

Question 1

What is the function of behavioral approaches?

Answer 1

To get a “feel” for a project’s risk, whereas other approaches try to quantify & measure the project’s risk.

Question 2

What are the behavioral approaches in dealing w/ risk in capital budgeting?

Answer 2

1. Breakeven analysis
2. Scenario analysis
3. Simulation

Question 3

Besides using the NPV method to decide how to invest the firm’s money, what is another important thing that CEOs said?

Answer 3

Their gut feel for a project was an important factor in their decision.

Question 4

What are the functions of Breakeven analysis?

Answer 4

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)

Question 5

For break-even analysis, what happens after we found the breakeven cash infow aka ordinary annuity (PMT)?

Answer 5

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.

Question 6

Scenario analysis

Answer 6

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.

Question 7

In scenario analysis, how do we determine if the project is more risky or less risky?

Answer 7

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.

Question 8

Simulation

Answer 8

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.

Question 9

What are the 2 types of international risks?

Answer 9

1. 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.
2. Political risks: arises from the possibility that a host gov will take actions harmful to foreign investors or that political turmoil will endanger investments.

Question 10

What are some of the special issues that are relevant only for international capital budgeting?

Answer 10

1. 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.
2. 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.

Question 11

What are the 2 opportunities to adjust the PV of cash inflows for risk:

Answer 11

1. The cash inflows can be adjusted.
2. 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

Question 12

Risk Adjusted Discount Rates (RADR)

Answer 12

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.

Question 13

Is it true that when there is higher risk, there’ll be higher NPV?

Answer 13

Yes

Question 14

What is the formula for CAPM in computing the risk adjusted discount rates (RADRs)?

Answer 14

Total risks = Nondiversifiable risk (systematic risk) + Diversifiable risk (unsystematic risk)
r = Rf + (Rm-Rf)ß

Question 15

Any project having an IRR above the SML would be acceptable. Is this true?

Answer 15

Yes, because its IRR would exceed the required return. Any project with an IRR below the return of project would be rejected.

Question 16

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?

Answer 16

Yes.

Question 17

What happens when IRR is greater than the required return?

Answer 17

This indicates that NPV is +ve, hence the project should be accepted.

Question 18

What does CAPM assumes?

Answer 18

CAPM is based on an assumed efficient market, which does not always exist for real corporate assets.

Question 19

How do most firms determine the risk adjusted discount rate?

Answer 19

By adjusting their exisitng required return.

Question 20

What is the function of risk indexes?

Answer 20

It is merely a numerical scale used to classify project risk. Normally projects w/ higher risk are assigned higher risk index value.

Question 21

When risk index increases, its required return increases too. Is this true?

Answer 21

Yes.

Question 22

What are portfolio effects?

Answer 22

It says the investors are not rewarded for taking diversifiable risk, therefore they should hold a diversified portfolio of securities to eliminate that risk.

Question 23

Is it important that the firm maintain a diversified portfolio of asset?

Answer 23

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.

Question 24

Why are firms not rewarded for diversification?

Answer 24

• 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

Question 25

Why are Risk-Adjusted Discount Rates often used in practice?

Answer 25

• they are consistent w/ the general disposition of financial decision makers towards rate of return
• they are easily estimated & applied based on the computational convenience and well-developed procedures involved

Question 26

What are the different classes of risk?

Answer 26

1. Below-average risk: projects w/ low risk. Involves routine replacement w/o renewal of existing activities
2. Average risk: projects similar to those currently implemented. Involves replacement or renewal of existing activities
3. Above-average risk: projects w/ higher than normal, but not excessive risk. Involves expansion of existing similar activities
4. Highest risk: projects w/ very high risk. Involves expansion into new or unfamiliar activities

Question 27

What happens if we need to choose a best project of a group of mutually exclusive projects w/ different usable lives?

Answer 27

Then we’ll have to use the annualized net present value (ANPV) in deciding which project gives out the highest ANPV.

Question 28

What is Annualized Net Present Value (ANPV)?

Answer 28

It is an approach to evaluate unequal-lived projects that converts the NPV of unequal-lived, mutually exclusive projects into an equivalent annual amount.

Question 29

What is the formula for ANPV?

Answer 29

NPV / [(1-(1+r)^-n) / r]

Question 30

What are real options aka strategic options?

Answer 30

They are opportunities that are embedded in capital projects and enables managers to alter their cash flows and risk in a way that affects project acceptability.

Question 31

What is the benefit of real options?

Answer 31

By explicitly recognizing real options when making capital budgeting decisions, managers can improve, more strategic decisions that consider in advance the economic impact of certain contingent actions on project cash flow and risk.
NPV(strategic) = NPV (traditional) + Value of real options

Question 32

What are the major types of real options?

Answer 32

1. Abandonment option - to abandon or terminate a project prior to the end of its planned life. Management can avoid or minimize losses on projects that turn bad. This in turns increases the NPV.
2. Flexibility option - incorporate flexibility into the firm’s operations, especially production. Includes opportunity to redesign the production process to accept multiple inputs, using flexible production technology to create a variety of outputs. Recognition of this option embedded in capital expenditure should increase the NPV of the project.
3. Growth option - develop follow-on projects, expand markets, expand or retool plants that would not be possible w/o implementation of the project being evaluated. Recognition of cash flows from such opportunities should be included in the initial decision process. This increases the NPV of project in which they are embedded.
4. Timing option - determine when various actions w/ respect to given project are taken. Recognizes the firm’s opportunity to delay acceptance of a project for one or more periods, to accelerate or slow the process of implementing a project in response to new info, or to shut down temporarily in response to changing product market conditions or competition. This improves the NPV of project that fails to recognize this option in an investment decison.

Question 33

What is capital rationing?

Answer 33

Firms commonly operate under capital rationing in that they have more acceptable independent projects than they can actually afford to fund.
In theory, capital rationing shouldn’t exist.
Firms should accept all projects that have +ve NPVs (IRR > WACC)

Question 34

What is the Internal Rate of Return approach?

Answer 34

It is an approach to capital rationing that involves graphing project IRRs in descending order against the total dollar investment to determine the group of acceptable projects.

Drawback of this approach: Offers no guarantee that the acceptance of projects will maximize the total dollar returns and therefore the owners’ wealth.

Question 35

Where there is capital rationing, how do we choose the best projects?

Answer 35

We just in descending order based on its Internal Rate of Return and we have to consider its initial investment as well so that we don’t exceed the budget constraint.
Note: If IRR is less than the cost of capital, then we can straight reject the project ady, there’s no point considering.

Question 36

What is the Net Present Value approach?

Answer 36

It is based on the use of present values to determine the group of projects that’ll maximize owners’ wealth. This is implemented by ranking projects on the basis of IRRs & evaluating the present value of benefits from each potential project to determine the combination of projects w/ the highest overall present value. (maximizing NPV)