Chapter 11 IM 10th Ed

Chapter 11 IM 10th Ed - CHAPTER 11 Capital Budgeting and...

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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. What measure of risk is relevant in capital budgeting. A. In capital budgeting, a project can be looked at on three levels. 1. First, there is the project standing alone risk, which is a project’s risk ignoring the fact that much of this risk will be diversified away as the project is combined with the firm’s other projects and assets. 2. Second, we have the project’s contribution-to-firm risk, which is the amount of risk that the project contributes to the firm as a whole; this measure considers the fact that some of the project’s risk will be diversified away as the project is combined with the firm’s other projects and assets, but ignores the effects of diversification of the firm’s shareholders. 3. Finally, there is systematic risk, which is the risk of the project from the viewpoint of a well-diversified shareholder; this measure considers the fact that some of a project’s risk will be diversified away as the project is combined with the firm’s other projects, and, in addition, some of the remaining risk will be diversified away by shareholders as they combine this stock with other stocks in their portfolio. 29
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B. Because of bankruptcy costs and the practical difficulties involved in measuring a project’s level of systematic risk, we will give consideration to the project’s contribution-to-firm risk and the project’s systematic risk. III. 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 analysis. 1. In effect, a riskless set of cash flows is substituted for the original set of cash flows between which the financial manager is indifferent. 2. To simplify calculations certainty equivalent coefficients ( t '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: α t = t t flow cash risky flow cash certain 4. 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.
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