CHAPTE

13

RISK AND
CAPITAL
BUDGETING

PowerPoint Presentation Prepared by Michel Paquet, SAIT Polytechnic

2015 McGraw-Hill Ryerson Ltd. All Rights Reserved

13-1

Chapter 13 - Outline
Definition of Risk
Concept of Risk Aversion
Statistical Measurements of Risk
Methods Dealing with Risk in the Capital
Budgeting Process
Portfolio Effect
Summary and Conclusions

13-2

Learning Objectives
1. Describe the concept of risk based on the
uncertainty of future cash flows. (LO1)
2. Characterize most investors as risk averse.
(LO2)
3. Analyze risk as standard deviation, coefficient
of variation or beta. (LO3)
4. Integrate the basic methodology of riskadjusted discount rates for dealing with risk in
capital budgeting analysis. (LO4)

13-3

Learning Objectives
5. Describe and apply the techniques of
certainty equivalents, simulation models,
sensitivity analysis and decision trees to
help assess risk. (LO5)
6. Assess how a projects risk may be
considered in a portfolio context. (LO6)

13-4

Definition of Risk
Variability of possible outcomes:
= standard deviation
Government of Canada Treasury bill have no
variability in cash flow:
no risk
Gold-mining expedition in Borneo has high
variability of possible outcomes:
great risk
Risk measured not only in terms of possible loss
or gain but uncertainty.
LO1

13-5

Where is the Beef?

https://
www.youtube.com/watch?v=R6_eWWfNB
54
https://
www.youtube.com/watch?v=idnwh6iDnXA
We often tend to think of Risk as potential
for loss; but in business risk can also
translate to potential of extreme gains
causing other problems! Ex: Wendys
widely successful commercial campaign in
13-6

The Concept of Risk Aversion

Avoiding risk:
preference for relative certainty to uncertainty.

To take risks, higher returns are expected

A risk-return tradeoff exists
return

risk
LO2

13-7

Table 13-1

Probability distribution of outcomes

LO3

Outcome

Probability of Outcome

Assumptions

$300

.2

Pessimistic

600

.6

Moderately successful

900

.2

Optimistic

13-8

Statistical Measurements of Risk

Expected Value:

weighted average of possible outcomes (forecasts) times their

probabilities
the most likely forecast (best estimate)

Standard Deviation:

measure of dispersion or variability around the expected value

measure of the spread of possible outcomes
larger the standard deviation greater the risk

Coefficient of Variation: V
standard deviation / expected value
allows comparison of investments of different sizes
larger the coefficient of variation greater the risk

LO3

13-9

Check your understanding

P. 470: #2 ( 5-7 Min.)

13-10

13-11

Check your understanding

P. 470; # 1 ( 5 Min.)

13-12

13-13

Which Investment is the Riskiest?

With the same expected value, the
standard deviation is a good measure of
risk.
Investments with quite different expected
values, require the coefficient of variation
to better measure risk.

LO3

13-14

Journal Exercises
P. 471; # 5 & #6 (15-20 Min.)

13-15

13-16

Risk in a Portfolio
Statistical measure of volatility (risk) (covariance/market
covariance)
measures how responsive or sensitive a companys stock is to
market movements in general

An individual stocks beta shows how risky it compares to

the market as a whole:
beta = 1 means equal risk with the market
beta > 1 means more risky than the market
beta < 1 means less risky than the market

Company risk may provide guideline to risk of a new

investment in that company

LO3

13-17

13-18

Table 13-2

Betas, June 2014

Company Name

Beta

Bombardier (BBD.B)...

1.70

Canadian Tire (CTC)..

0.56

Power Corp. (POW).......

1.07

Potash Corp. (POT)....

0.85

Blackberry (BB)......

1.17

Royal Bank (RY).........

1.11

Teck (TCK.B)...

2.62

Telus (T)....

0.31

Source: www.reuters.com/finance/stocks
http://pages.stern.nyu.edu/~adamovar/New_Home_Page/data.html

LO3

13-19

Risk and the Capital Budgeting

Process
1. adjusting the discount rate to reflect the risk
level associated with an investment proposal
2. converting cash flows to their certainty
equivalents
3. simulating various economic and financial
outcomes with the help of a computer
4. testing the sensitivity of a projects success to
some key variables
5. using a decision tree
LO4

13-20

Figure 13-5
Relationship
of
risk to
discount
rate

LO4

13-21

Table13-3

Risk classes and associated discount rates

Discount Rate
Low or no risk (repair to old machinery)

6%

Moderate risk (new equipment)..

Normal risk (addition to normal product line)...

10

Risky (new product in related market....

12

High risk (completely new market).

16

Highest risk (new product in foreign market)

20

LO4

13-22

Table 13-4

Capital Budgeting Analysis

Investment A
(10% discount rate)

Year

Year

Investment B
(10% discount rate)

$5,000

$ 4,545

$1,500

$ 1,364

5,000

4,132

2,000

1,653

2,000

1,503

2,500

1,878

$10,180

5,000

3,415

5,000

3,105
$11,415

Present value of
inflows
Investment
Net Present value

LO4

$10,180
10,000
$ 180

Present value of inflows

Investment
Net present value

$11,415
10,000
$1,415

13-23

Table 13-5

Capital budgeting decision adjusted for risk

Investment A
(10% discount rate)

Year

Greater risk
Year

Investment B
(20% discount rate)

$5,000

$ 4,545

$1,500

$ 1,250

5,000

4,132

2,000

1,389

2,000

1,503

2,500

1,447

$10,180

5,000

2,411

5,000

2,009
$ 8,506

Present value of inflows $10,180

Present value of inflows

Investment

Investment

Net Present value

LO4

10,000
$

180

Net present value

$ 8,506
10,000
$(1,494)

13-24

Certainty Equivalents
Year of Uncertain Cash Flow

Value as Certain Cash Flow

85%

80%

65%

Cost of capital is 13%, risk-free rate of return is 5%.

A proposal costing $1,100 has the following pattern of cash flows and certainty equivalents:

Year

Cash Flow

Certainty Equivalent

$500

$425 (500 x 85%)

600

480 (600 x 80%)

800

520 (800 x 65%)

NPV of this proposal using the certainty equivalents and risk-free rate for discount purposes is $189

Year

Certainty Equivalent

Present Value

-$1,100

-$1,100

425

405

480

435

520

449
NPV = $189

LO5

13-25

Figure 13-8

Decision trees

LO5

13-26

Check your understanding

P. 473; # 16 (10 Min.)

13-27

13-28

Journal Exercise
P. 473: # 15 Westurn Dynamite
( 5-7 Min.)

13-29

13-30

Portfolio Effect
Risk inherent in an individual investment () is
not enough.
Impact of a given investment on the overall risk
of the firm the portfolio effect should also be
taken into account.
Overall risk of the portfolio depends on its
relationship to other investments measured
as the covariance
The covariance is brought to a standardized
scale known as the coefficient of correlation.
LO6

13-31

Portfolio Equations
Expected
value:
Covariance:

Coefficient of
correlation:
Portfolio
standard
deviation:
Portfolio
standard
deviation:
LO6

D p xi Di

(13- 4)

CovAB P ( D Di )( F Fi )
AB

CovAB

A B

(13- 6)

AB xA A xB B 2CovAB xA xB
2

AB xA A xB B 2 AB A B xA xB
2

(13- 5)

(13- 7)

(13- 8)
13-32

Portfolios
Covariance becomes more significant in a portfolio than variance
An individual investment might be quite risky itself but it may
reduce a portfolios risk (standard deviation) if it has a negative
coefficient of correlation with the other investments
In a portfolio with less than perfectly correlated investments, risk is
reduced
Unsystematic or unique risk is eliminated (to a large extent)
Systematic risk thus properly describes the risk-return
relationship (leading to the CAPM)
Investors will price assets on systematic risk if diversification can
be achieved

LO6

13-33

Table13-6

Measures of correlation
Coefficient of
Correlation
-1

0
+1

Condition

Example

Impact on Risk

Negative correlation Electronic

components, food
products

Large risk reduction

No correlation

Beer, textiles

Some risk reduction

Positive correlation

Two airlines

No risk reduction

Coefficient of correlation shows the extent of

correlation among projects
Has a numerical value of between -1 and +1
LO6

13-34

Figure 13-10
Levels of risk reduction as measured by the coefficient
of correlation
Very few investment combinations take on extreme values of coefficient of
correlation. More likely case is a point somewhere in between, such as a
negative correlation of -.2 or a positive correlation of +0.3 as shown on the
continuum below.

Extreme
risk
reduction

Significant
Risk
Reduction
-1

-.5

Some
Risk
Reduction
-.2

Minor
Risk
Reduction
+.3

+.5

No
+1 reduction

The Coefficient of Correlation is not the same as the Coefficient of Variation

(Chapter 12)
LO6

13-35

The Efficient Frontier

Firm chooses combinations of projects with the best tradeoff between risk and return
2 primary objectives of management:
1. Achieve the highest possible return at a given risk
level
2. Provide the lowest possible risk at a given return
level
The Efficient Frontier is the best risk-return line or
combination of possibilities
Firm must decide where to be on the risk-return line
(there is no right answer)
LO6

13-36

The Share Price Effect

Firm must be sensitive to the wishes and demands of
shareholders
Aversion of investors to unpredictability (and risk) is confirmed
by the fluctuations in share price of cyclical stocks
compared to more predictable growth stocks
Each company must analyze its own situation to determine
the appropriate tradeoff between risk and return.

LO6

13-37

Figure 13-11
Risk-return
tradeoffs

LO6

13-38

Summary and Conclusions

Risk may be defined as the variability or uncertainty of
the potential outcomes from an investment.
Investors and managers tend to be risk averse.
Standard deviation, coefficient of variation and beta
are statistical measures of risk.
The methods dealing with risk in the capital budgeting
process include adjusting the discount rate,
calculating certainty equivalents, simulating,
analyzing sensitivity and using a decision tree.
Management must consider not only the individual
projects risk, but also the portfolio effect.

13-39

End of chap assgt.

P. 476; # 24

13-40

13-41