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Unformatted text preview: 111 CHAPTER 11 Capital Budgeting and Risk Analysis CHAPTER ORIENTATION The focus of this chapter will be on how to adjust for the riskiness of a given project or combination of projects. CHAPTER OUTLINE I. Risk and the investment decision A. Up to this point we have treated the expected cash flows resulting from an investment proposal as being known with perfect certainty. We will now introduce risk. B. The riskiness of an investment project is defined as the variability of its cash flows from the expected cash flow. II. Methods for incorporating risk into capital budgeting A. The certainty equivalent approach involves a direct attempt to allow the decision maker to incorporate his or her utility function into the 112 analysis. 1. In effect, a riskless set of cash flows is substituted for the original set of cash flows between both of which the financial manager is indifferent. 2. To simplify calculations certainty equivalent coefficients (αt's) are defined as the ratio of the certain outcome to the risky outcome between which the financial manager is indifferent. 3. Mathematically, certainty equivalent coefficients can be defined as follows: αt= certain cash flowtrisky cash flowt4. The appropriate certainty equivalent coefficient is multiplied by the original cash flow (which is the risky cash flow) with this product being equal to the equivalent certain cash flow. 5. Once risk is taken out of the cash flows, those cash flows are discounted back to present at the riskfree rate of interest and the project's net present value or profitability index is determined. 6. If the internal rate of return is calculated, it is then compared with the riskfree rate of interest rather than the firm's required rate of return. 7. Mathematically, the certainty equivalent can be summarized as follows: NPV = nΣt=1αtACFt(1 + iF)t IO 113 where ατ= the certainty equivalent coefficient for time period t ACFt= the annual aftertax expected cash flow in time period t IO = the initial cash outlay n = the project's expected life iF= the riskfree interest rateB. The use of the riskadjusted discount rate is based on the concept that investors demand higher returns for more risky projects. 1. If the risk associated with the investment is greater than the risk involved in a typical endeavor, then the discount rate is adjusted upward to compensate for this risk. 2. The expected cash flows are then discounted back to present at the riskadjusted discount rate. Then the normal capital budgeting criteria are applied, except in the case of the internal rate of return, in which case the hurdle rate to which the project's internal rate of return is compared now becomes the riskadjusted discount rate....
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This note was uploaded on 02/20/2010 for the course FIN 565 taught by Professor Libnitz during the Spring '10 term at Academy of Design Tampa.
 Spring '10
 LIbnitz
 Finance

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