This week’s overarching topic is risk and refinement in capital budgeting. Please share your observations and takeaways of this week’s learning objectives as they relate to your job/role. How does risk and refinement in capital budgeting impact you personally and/or what impact does risk and refinement in capital budgeting have on your professional role?
Principles of Managerial Finance
Sixteenth Edition
Chapter 12
Risk and Refinements in Capital
Budgeting
Copyright © 2022, 2019, 2015 Pearson
Education, Inc. All Rights Reserved.
Learning Goals (1 of 2)
LG 1 Understand the different forms of break-even analysis
and how operating leverage influences project risk.
LG 2 Discuss sensitivity analysis, scenario analysis, and
simulation as approaches for dealing with risk.
LG 3 Review the unique risks that multinational companies face.
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Learning Goals (2 of 2)
LG 4 Describe the determination and use of riskadjusted discount rates (RADRs), portfolio
effects, and the practical aspects of RADRs.
LG 5 Select the best of a group of unequal-lived,
mutually exclusive projects using annualized
net present values (ANPVs).
LG 6 Explain the role of real options and the
objective and procedures for selecting
projects under capital rationing.
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12.1 Assessing Risk in
Capital Budgeting (1 of 17)
•
•
•
In our discussion of capital budgeting thus far, we
have applied analytical techniques such as N P V and I
R R to describe how managers can decide to accept
or reject an investment idea based on its projected
cash flows
In reality, the decision to invest is not based on a
single, binary metric. It involves layers of analysis.
Calculating a project’s N P V or I R R is just a first step
in deciding whether an investment is worth pursuing
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12.1 Assessing Risk in
Capital Budgeting (2 of 17)
• Managers want to know:
• what risks are embedded in an investment project
• how sensitive its payoff is to different assumptions
• the requirements for the investment to at least break even
• how bad the worst outcomes might be for the company
• We begin this chapter by focusing on
how managers evaluate the risks of
different projects
s)
-3,494,400
-3,494,400
-3,494,400
-3,494,400
-3,494,400
Gross profit (40% of sales)
2,329,600
2,329,600
2,329,600
2,329,600
2,329,600
Operating expenses (15%
of sales)
-873,600
-873,600
-873,600
-873,600
-873,600
Depreciation
-1,000,000
-1,000,000
-1,000,000
-1,000,000
-1,000,000
Pre-tax profit
456,000
456,000
456,000
456,000
456,000
Taxes (21%)
-95,760
-95,760
-95,760
-95,760
-95,760
Net income
360,240
360,240
360,240
360,240
360,240
Add back depreciation
1,000,000
1,000,000
1,000,000
1,000,000
1,000,000
Cash flow
1,360,240
1,360,240
1,360,240
1,360,240
1,360,240
5
$1,360, 240
t ?1
(1.10 )
NPV = ?$5, 000, 000 + ?
t
= $156,380
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Table 12.5 MyPad Project’s Cash Flows,
NPV, and Sensitivity Analysis (2 of 2)
Panel B: Sensitivity Analysis of MyPad Project NPV
Input
Low Value
Price
$108
$ 654
$ 116
$312,105
$107.98
48,000
-179,029
56,000
491,789
50,135
Gross profit margin
37%
-366,856
43%
679,618
39.1%
Operating expenses
13%
505,205
17%
-192,445
15.9%
Units sold
NPV
High Value
NPV
Value such
that
NPV = 0
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12.1 Assessing Risk in Capital
Budgeting (16 of 17)
•
• Like sensitivity analysis, scenario analysis is designed to
Scenario Analysis
•
•
see how a project’s NPV responds to changes in its key
assumptions
Scenario analysis calculates a project’s NPV under a
handful of scenarios in which multiple assumptions
change (from the baseline forecast) at the same time
One of the most common scenario approaches is to
estimate the NPVs associated with pessimistic (worst),
most likely (expected), and optimistic (best) estimates of
cash inflow and find the range by subtracting the
pessimistic-outcome NPV from the optimistic-outcome
NPV
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Example 12.10 (1 of 2)
Continuing with the MyPad investment project, managers
at Turing Trinkets have identified a set of conditions that
they consider to be the best-case and worst-case
scenarios (the most likely scenario was presented in
Table 12.5). In the best case, the company will sell
56,000 units per year at a price of $116. By selling at a
high price, Turing will achieve a gross profit margin of
43%. Spread out over high volume, operating expenses
will be just 13% of sales. Under these conditions, Table
12.6 shows that the annual cash flow from the
investment is $1,749,552 and the project’s NPV is
$1,632,179.
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Example 12.10 (2 of 2)
The worst-case scenario envisions a selling price of just $108,
unit volume of $48,000 per year, a gross margin of 37%, and
operating expenses equal to 17% of sales. Under these
conditions, annual project cash flow falls to $1,029,072 and the
NPV is just – $1,099,007. The range in NPVs between the best
and worst scenarios is $2,731,186.
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Table 12.6 Scenario Analysis of
MyPad Project
Initial investment
– +5,000,000
Annual Cash Flow
Pessimistic
$1,029,072
Most likely
1,360,240
Optimistic
1,749,552
Range ($1,749,552 – $1,029,072)
$720,480
Net Present Values
Pessimistic
– +1,099,007
Most likely
156,380
Optimistic
1,632,179
Range [$1,632,179 – (–$1,099,007)]
$2,731,186
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12.1 Assessing Risk in Capital
Budgeting (17 of 17)
• Simulation
• A statistics-based approach that applies predetermined
probability distributions to each of a model’s key inputs
and simulates a project’s NPV by taking random draws
from those distributions
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Figure 12.3 NPV Simulation
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12.2 International Risk
Considerations (1 of 7)
•
Although the basic techniques of capital budgeting are the
same for multinational companies (MNCs) as for purely
domestic firms, firms that operate in several countries face
risks unique to the international arena
•
Two types of risk—exchange rate risk and political risk—are
particularly important
• Exchange Rate Risk
• The possibility that an unexpected change in the
exchange rate between the dollar and the currency in
which a project’s cash flows are denominated will
change the market value of that project’s cash flow
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Matter of Fact (2 of 2)
Adjusting for Currency Risk
A survey of chief financial officers (CFOs) found that
more than 40% of the CFOs believed it was important to
adjust an investment project’s cash flows or discount
rates to account for foreign exchange risk
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12.2 International Risk
Considerations (2 of 7)
• Two types of risk—exchange rate risk
and political risk—are particularly
important.
• Political Risk
• Risk
that arises from the possibility that a host government
will take actions harmful to foreign investors or that political
turmoil will endanger investments
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12.2 International Risk
Considerations (3 of 7)
• In addition to unique risks that MNCs
must face, several other special issues
are relevant only for international capital
budgeting
• One of these special issues is taxes
• Because
only after-tax cash flows are relevant for capital
budgeting, financial managers must carefully account for taxes
•
paid to foreign governments on profits earned within their
borders
They must also assess the impact of these tax payments on
the parent company’s U.S. tax liability
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12.2 International Risk
Considerations (4 of 7)
•
Another special issue in international capital
budgeting is transfer pricing
• Transfer Prices
• Prices
that subsidiaries charge each other for the goods and services
traded between them
•
Much of the international trade involving MNCs
is, in reality, simply the shipment of goods and
services from one of a parent company’s
subsidiaries to another subsidiary located abroad
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12.2 International Risk
Considerations (5 of 7)
•
The parent company therefore has some discretion in
setting transfer prices
• The widespread use of transfer pricing in international
trade makes capital budgeting in MNCs very difficult
unless the transfer prices that are used accurately
reflect actual costs and incremental cash flows
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12.2 International Risk
Considerations (6 of 7)
• MNCs often must approach
international capital projects from a
strategic, rather than strictly financial,
point of view
• For
example, an MNC may feel compelled to invest in a
country to ensure continued access, even if the project itself
•
•
may not have a positive net present value
This motivation was important for Japanese automakers that
set up assembly plants in the United States in the early 1980s
For much the same reason, U.S. investment in Europe surged
during the years before the market integration of the European
Community in 1992
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12.2 International Risk
Considerations (7 of 7)
•
MNCs often must approach international capital projects
from a strategic, rather than strictly financial, point of view
MNCs often invest in production facilities in the home
country of major rivals to deny these competitors an
uncontested home market
MNCs also may feel compelled to invest in certain
industries or countries to achieve a broad corporate
objective, such as completing a product line or
diversifying raw material sources, even when the
project’s cash flows may not be sufficiently profitable
•
•
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12.3 Risk-Adjusted Discount Rates
(1 of 10)
•
The approaches for dealing with risk presented
so far enable financial managers to get a “feel”
for project risk, but they don’t quantify risk in a
way that tells managers what discount rate is
appropriate for any particular project
• To assign a discount rate to a project,
managers need to quantify project risk and then
map that into an appropriate rate of return
• The Capital Asset Pricing Model (CAPM) provides one way to do that
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12.3 Risk-Adjusted Discount Rates
(2 of 10)
• Determining Risk-Adjusted Discount
Rates (RADRs)
• Risk-Adjusted Discount Rate (RADR)
• The
rate of return that an investment must earn to
compensate the firm’s owners for the project’s risk
• The
higher the risk of the project, the higher the RADR and
therefore the lower the NPV for a given stream of cash
flows
n
CFt
? CF0
t
t =1 (1 + RADR )
NPV = ?
(12.7)
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Personal Finance Example
12.11 (1 of 3)
Talor Namtig is considering investing $1,000 in either of
two stocks, A or B. She plans to hold the stock for exactly
five years and expects both stocks to pay $80 in annual
end-of-year cash dividends. After five years, she
estimates that she will sell stock A for $1,200 and stock B
for $1,500. Talor has carefully researched the two stocks
and believes that although stock A has average risk, stock
B is considerably riskier. Her research indicates that she
should earn an annual return on an average-risk stock of
11%.
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Personal Finance Example
12.11 (2 of 3)
Because stock B is considerably riskier, she will require a
14% return from it. Talor makes the following
calculations to find the risk-adjusted net present values
(NPVs) for the two stocks:
$80
$80
$80
$80
NPVA =
+
+
+
1
2
3
(1 + 0.11) (1 + 0.11) (1 + 0.11) (1 + 0.11) 4
$80
$1,200
+
+
? $1,000 = $7.81
5
5
(1 + 0.11) (1 + 0.11)
$80
$80
$80
$80
NPVB =
+
+
+
(1 + 0.14)1 (1 + 0.14) 2 (1 + 0.14)3 (1 + 0.14) 4
$80
$1,500
+
+
? $1,000 = $53.70
5
5
(1 + 0.14) (1 + 0.14)
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Personal Finance Example
12.11 (3 of 3)
Although Talor