Chapter 13 Risk and Capital Budgeting

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. PPT 13-1 FIGURE 13-1 Variability and risk

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. PPT 13-2 FIGURE 13-3 Probability distribution with differing degrees of risk

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. PPT 13-3 TABLE 13-2 Betas for five-year period (ending January 2003)

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. PPT 13-4 FIGURE 13-5 Relationship of risk to discount rate

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. PPT 13-5 TABLE 13-3 Risk categories and associated discount rates

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. PPT 13-6 TABLE 13-4 Capital budgeting analysis

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. PPT 13-7 TABLE 13-5 Capital budgeting decision adjusted for risk

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. PPT 13-8 FIGURE 13-7 Simulation flow chart

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. PPT 13-9 FIGURE 13-8 Decision trees

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. PPT TABLE 13-7 Rates of return for Conglomerate, Inc., and two merger candidates

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. PPT FIGURE Risk-return trade-offs

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Chapter 13 - Outline LT 13-1 What is Risk? Statistical Measurements of Risk Beta Coefficient of Correlation The Efficient Frontier

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. What is Risk? LT 13-2 Risk means uncertainty about a future outcome Risk varies greatly depending on the investment: –A T-Bill has zero or no risk – A gold-mining expedition in Africa has high risk Most investors and financial managers are risk averse, meaning they don’t like risk

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Statistical Measurements of Risk LT 13-3 Expected Value: – equal to weighted average of outcomes x probabilities Standard Deviation: – measure of dispersion or variability around the expected value – the larger the standard deviation  the greater the risk Coefficient of Variation: – equal to standard deviation / expected value – the larger the coefficient of variation  the greater the risk

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Beta LT 13-4 Beta is a statistical measure of volatility It measures how responsive or sensitive a stock is to market movements in general An individual stock’s beta shows how 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

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Coefficient of Correlation LT 13-5 Shows the extent of correlation among projects Has a numerical value of between -1 and +1 Its value shows the risk reduction between projects: Negative correlation (-1)  Large risk reduction No correlation (0)  Some risk reduction Positive correlation (+1)  No risk reduction Coefficient of Correlation  Coefficient of Variation

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. The Efficient Frontier LT 13-6 Firm chooses combinations of projects with the best trade- off between risk and return 2 objectives of management: – Achieve the highest possible return at a given risk level – 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 line (there is no “right” answer)