1. 13 Chapter Risk and Capital Budgeting McGraw-Hill Ryerson
©2003 McGraw-Hill Ryerson Limited

2. DETERMINATION OF APPROPRIATE DISCOUNT RATE CAPITAL BUDGETING PROJECTS
Chapter Objective
DETERMINATION OF APPROPRIATE DISCOUNT RATE
FOR
CAPITAL BUDGETING PROJECTS

3. PPT 13-3
What is Risk?
Investment proposals are judged on the basis of return and risk
Risk means uncertainty about a future outcome
Investments are risky because future cash flows will likely vary from forecasts
Risk varies greatly, depending on the investment:
A T-Bill has zero or no risk
Nortel at $120 had high risk
Most investors and managers don’t like risk
The maximum risk acceptable depends on the investor’s aversion to risk
The higher the risk, the higher the required return

4. Methods of Dealing With Risk
PPT 13-4
Methods of Dealing With Risk
Compute the Expected Value and Standard Deviation
Compare the risk of the investment to the company’s Beta
Increase the discount rate for riskier projects
Certainty equivalents - adjust cash flows estimates for risk

5. Statistical Measurement of Risk
PPT 13-6
Statistical Measurement of Risk
Expected Value:
equals the weighted average of possible outcomes (forecasts) times their probabilities
Gives you the most likely forecast / your best estimate
Standard Deviation:
measure of dispersion or variability around the expected value
gives you a measure of the spread of possible outcomes
larger the standard deviation  greater the risk

6. Beta Beta is a statistical measure of volatility
PPT 13-13
Beta
Beta is a statistical measure of volatility
It measures how responsive or sensitive a company’s 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
Company risk may provide guideline to risk of a new investment in that company

7. Table 13-2 Betas, 2002 PPT 13-14 Company Name Beta
Air Canada
Alcan Aluminum
BCE Inc
Inco
Nortel
Royal Bank
Source:
Home Page/datafile/Betas.html

8. Figure 13-5 Relationship of risk to discount rate
PPT 13-15
Figure 13-5 Relationship of risk to discount rate
Discount rate
(per cent) 20 15 10 6
.30
.60
.90
1.20
Risk (β)
10% cost
of capital +
5% risk
premium
Cost of
capital
Risk-free
rate
Extreme risk
Normal
risk
Discount
rate

9. Table 13-3 Risk categories and associated discount rates
PPT 13-16
Table 13-3 Risk categories and associated discount rates
Discount
Rate
Low or no risk (repair to old machinery) %
Moderate risk (new equipment)
Normal risk (addition to normal product line)
Risky (new product in related market)
High risk (completely new market)
Highest risk (new product in foreign market)

10. Table 13-4 Capital budgeting analysis
PPT 13-17
Table 13-4 Capital budgeting analysis
Investment A Investment B
Year (10% discount rate) Year (10% discount rate)
P.V P.V.
1 $5, $4,545 1 $1, $1,364
2 5, , , ,653
3 2, , , ,878
$10, , ,415
5 5, ,105
$11,415
Present value of inflows $ 10,180 Present value of inflows $11,415
Investment ,000 Investment ,000
Net present value $ Net present value $ 1,415

11. Table 13-5 Capital budgeting decision adjusted for risk
PPT 13-18
Table 13-5 Capital budgeting decision adjusted for risk
Investment A Investment B
Year (10% discount rate) Year (20% discount rate)
1 $5, $4,545 1 $1, $1,250
2 5, , , ,389
3 2, , , ,447
$10, , ,411
5 5, ,009
$ 8,506
Present value of inflows $10,180 Present value of inflows $ 8,506
Investment ,000 Investment ,000
Net present value $ Net present value $ (1,494)

12. Summary and Conclusions
PPT 13-26
Summary and Conclusions
Risk is considered as the variability of the potential outcomes from an investment
Managers tend to be risk-adverse
Methods of incorporating risk in capital budgeting include: standard deviation and Beta
The portfolio effect considers the effect of a new investment on the overall risk of the firm