Risks related to capital budgeting

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Unformatted text preview: 00 571,410 414,720 288,050 Not given Project B: (A) Year Expected Cash Flow 0 1 2 3 4 -$1,000,000 500,000 600,000 700,000 800,000 (B) αt 1.00 .90 .70 .60 .50 (A x B) (Expected Cash Flow) x (αt) (TVM Table) Present Value Factor at 5% (Rf) Present Value -$1,000,000 450,000 420,000 420,000 400,000 1.000 .952 .907 .864 .823 -$1,000,000 428,400 380,940 362,880 329,200 NPVB = $ 501,420 Thus, project A should be selected, as it has a higher NPV. (NPV) Incorporating Risk into Capital Budgeting Capital Risk-Adjusted Discount Rate How can we adjust this model to take risk into account? to n NPV = NPV Σ t=1 FCFt FCF t (1 + k) - IO How can we adjust this model to take risk into account? to n NPV = NPV Σ t=1 FCFt FCF t (1 + k) - IO Adjust the discount rate (k). Risk-Adjusted Discount Rate Risk-Adjusted Simply adjust the discount rate (k) Simply adjust to reflect higher risk. to Riskier projects will use higher Riskier higher risk-adjusted discount rates. risk-adjusted Calculate NPV using the new riskadjusted discount rate. Risk-Adjusted Discount Rate Risk-Adjusted n NPV = Σ t=1 FCFt t - IO (1 + k*) Risk-Adjusted Discount Rates Risk-Adjusted How do we determine the How appropriate risk-adjusted discount rate (k*) to use? (k*) Many firms set up risk classes to Many risk categorize different types of projects. projects. Risk Classes Risk Risk RADR Risk Class (k*) Class 1 12% 12% 2 3 4 14% 16% 16% 24% 24% Project Type Replace equipment, Expand current business Expand Related new products Unrelated new products Research & Development Summary: Steps to capital budgeting Summary: 1. 2. 3. 4. 5. Estimate CFs (inflows & outflows). Assess riskiness of CFs. Determine the appropriate cost of capital. Find NPV and/or IRR or something else. Accept if NPV > 0 and/or IRR > WACC. What is Risk and Risk Management Risk What is Risk What Risk exists if there is something you don’t want to happen – having a chance to happen!!! What is Risk – Take 2 What The probability that some event wi...
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This document was uploaded on 02/03/2014.

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