Foundations of Financial Management: An Analysis (part 51)

“A bank is a place where they lend you an umbrella in fair weather and ask for it back when it begins to rain.” 

– Robert Frost

Risk and Capital Budgeting (part B)

by

Charles Lamson

Risk and the Capital Budgeting Process

How can risk analysis be used effectively in the capital budgeting process? So far, we have made no distinction between risky and non risky events. We showed the amount of the investment and the annual returns---making no comment about the riskiness or likelihood of achieving these returns. We know that enlightened investors and managers need further information. A $1,400 investment that provides "certain" returns of $600 a year for three years is not the same as a $1,400 investment that produces returns with an expected value of $600 for 3 years, but with a high coefficient of variation. Investors, being risk-averse by nature, will apply a stiffer test to the second investment. How can this new criterion be applied to the capital budgeting process?

Risk-Adjusted Discount Rate

A favorite approach to adjust for risk is to use different discount rates for proposals with different risk levels. Thus we use risk-adjusted discount rates a project that carries a normal amount of risk and does not change the overall risk composure of the firm should be discounted at the cost of capital. Investments carrying greater than normal risk will be discounted at a higher rate, and so on. In Figure 5 we show a possible risk-discount rate trade-off scheme. Risk is assumed to be measured by the coefficient of variation (V).

The normal risk for the firm is represented by a coefficient of variation of .30 on the bottom of Figure 5. An investment with this risk would be discounted at the firm's normal cost of capital of 10 percent. As the firm selects riskier projects, for example, with a V of 0.90, a risk premium of 5 percent is added to compensate for an increase in V of 0.60 (from .30 to .90). If the company selects a project with a coefficient of variation of 1.20, it will add another 5 percent risk premium for this additional V of 0.30. Notice that the same risk premium of 5 percent was added for a smaller increase in risk. This is an example of being increasingly risk-averse at higher levels of risk and potential return.

Increasing Risk over Time

Our ability to forecast accurately diminishes as we forecast further out in time. As the time horizon becomes longer, more uncertainty enters the forecast. These unexpected events create a higher standard of deviation in cash flows and increase the risk associated with long-lived projects.

Using progressively higher discount rates to compensate for risk tends to penalize late flows more than early flows, and this is consistent with the notion that risk is greater for longer-term cash flows than for near-term cash flows.

Qualitative Measures

Rather than relate the discount rate or required return to the coefficient of variation or possibly the beta, management may wish to set up risk classes based on qualitative considerations. Examples are presented in Table 3. Once again we are equating the discount rate to the perceived risk.

Table 3 Risk categories and associated discount rates

Example---Risk-Adjusted Discount Rate In parts 45 through 49 of this analysis, we compared two $10,000 investment alternatives and indicated that each had a positive net present value (at a 10 percent cost of capital). The analysis is represented in Table 4.

Table 4 Capital budgeting analysis

Though both proposals are acceptable, if they were mutually exclusive, only Investment B would be undertaken. But what if we add a risk dimension to the problem? Assume Investment A calls for an addition to the normal product line and is assigned a discount rate of 10 percent. Further assume that Investment B represents a new product in a foreign market and must carry a 20 percent discount rate to adjust for the large risk component. As indicated in Table 5, our answers are reversed and Investment A is now the only acceptable alternative.

Table 5 Capital budgeting decision adjusted for risk

Other methods besides the risk-adjusted discount rate approach are also used to evaluate risk in the capital budgeting process. The spectrum runs from a seat-of-the-pants "executive preference" approach to sophisticated computer-based statistical analysis. All methods, however, include a common approach---that is, they must recognize the riskiness of a given investment proposal and make an appropriate adjustment for risk. 

*MAIN SOURCE: BLOCK & HIRT, 2005, FOUNDATIONS OF FINANCIAL MANAGEMENT, 11TH ED., PP. 390-394*

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