1. FINANCE IN A CANADIAN SETTING Sixth Canadian Edition Lusztig, Cleary, Schwab

2. CHAPTER ELEVEN CHAPTER ELEVEN Capital Budgeting: Dealing with Risk Capital Budgeting: Dealing with Risk

3. Learning Objectives 1.Describe four techniques used for risk assessment. 2.Define risk-adjusted discounting and discuss some of the challenges in using it in the real world. 3.Name two alternative methods of evaluating risk and explain how they differ from risk-adjusted discounting.

4. Learning Objectives 4.Name some techniques (three +) for managing risk within a firm. 5.Discuss the concept of diversification in terms of the individual investor and the corporation.

5. Risk Assessment n Risk assessment – is concerned with estimating the amount of risk inherent in an investment The first step in dealing with risk is to estimate exposureThe first step in dealing with risk is to estimate exposure In practice, estimating the systematic risk or beta of a specific investment is often difficultIn practice, estimating the systematic risk or beta of a specific investment is often difficult

6. Risk Assessment Methods used in risk assessment include: Methods used in risk assessment include: Sensitivity and break-even analysis Analysis used to determine how vulnerable a project’s desirability is to changes in forecasted valuesAnalysis used to determine how vulnerable a project’s desirability is to changes in forecasted values Payback period Related to break-even analysis, payback period is the time required for its expected after-tax cash inflows to equal the original outlayRelated to break-even analysis, payback period is the time required for its expected after-tax cash inflows to equal the original outlay Simplistic measure, but often misleadingSimplistic measure, but often misleading

7. Risk Assessment 3. Monte Carlo Simulation A computer based technique that offers solutions, when direct solutions are not available, based on sampling, to problems of this type The technique calls for:The technique calls for: 1.Identification of key variables affecting the investments cash flow 2.Assignment of probability distribution to each variable 3.Specification of any statistical dependencies between variable

8. Risk Evaluation n Risk evaluation – when one adjusts the economic value of the project to reflect its risk since investors view uncertainty as undesirable When projects differ substantially from the average risk of the company, individual risk adjustments should take place in investment evaluations When projects differ substantially from the average risk of the company, individual risk adjustments should take place in investment evaluations A common approach to risk evaluation is the risk adjusted discount rates A common approach to risk evaluation is the risk adjusted discount rates

9. Practical Difficulties in Evaluating Risk In most cases, risk adjustments are made by management on an intuitive basis rather than applying CAPM or other models In most cases, risk adjustments are made by management on an intuitive basis rather than applying CAPM or other modelsWhy? 1.There are difficulties estimating the systematic risk for individual projects 2.Agency problems 3.Markets for real capital are much less developed

10. Other Approaches for Evaluating Risk Other short cut methods are used often alongside risk-adjusting discounting. These other methods tend to be ad hoc and without prescriptive or normative substance for example: Other short cut methods are used often alongside risk-adjusting discounting. These other methods tend to be ad hoc and without prescriptive or normative substance for example: - Conservation estimates - Project evaluation based on payback period

11. Risk Management n Risk management – techniques used to limit or control risk Risk is not entirely outside the firm’s control Risk is not entirely outside the firm’s control Certain aspects can and should be managed Certain aspects can and should be managed Techniques used to reduce risk include: Techniques used to reduce risk include: -Internal actions improving forecasting, planning and implementation -Financial engineering through hedges -Diversification

12. Summary 1.Widely used techniques for risk assessment include sensitivity and break-even analysis, payback period determination, and computer- based simulation. 2.Risk-adjusted discounting represents one of the most widely used techniques for evaluation risk. Here, the discount rate applied to individual projects is adjusted to reflect perceived risk. Conceptual difficulties of risk-adjusted discounting include the fact that time and risk become linked through the discounting process implying that risk increases with time in a specified manner.

13. Summary 3.Widely used alternative approaches to the evaluation of risk include conservative estimates and a shortening of the required payback period. 4.Risk can managed, at least to some extent, within the firm. Different techniques for doing this include: Improving forecasting through the use of better informationImproving forecasting through the use of better information Implementing various operating measures that enhance flexibility (such as subcontracting and renting rather than owning) (cont’d)Implementing various operating measures that enhance flexibility (such as subcontracting and renting rather than owning) (cont’d)

14. Summary Shifting risk through insurance-type arrangementsShifting risk through insurance-type arrangements Financial engineeringFinancial engineering DiversificationDiversification 5. Diversification depends largely on the correlation of cash flows between the various projects making up the firm’s business portfolio. Because diversification to reduce such correlations can be pursued by both firms and investors, it is not clear whether diversification at the corporate level provides the economic gains often ascribed to it by management.