Chapter 15 Project Risk Analysis

Question 1

Risk Analysis in Capital budgeting: 3 Elements

• Defining the type of risk relevant to the prject
• Measuring the risk
• Incorporating the risk assessment into the capital budgeting process

Ultimate goal in project risk analysis is to ensure that the cost of capital used as the discount rate in a project’s ROI analysis properly reflects the riskiness of that project.

Corporate cost of capital reflects the cost of capital to the organization based on its aggregate risk: The riskiness of the firm’s average project.

In project risk analysis, the risk of the project is compared to the firm’s average project

Answer 1

The Corporate cost of capital is adjusted to reflect any differential risk

Question 2

Three distinct types of financial risks

1. Stand-alone risk: Assumes the project is held in isolation and ignores portfolio effects
2. Corporate risk: Views the risks of a project within the context of the firm’s portfolio of projects
3. Market Risk: Views the project from the perspective of a business’s owner who holds a well-diversified protfolio of stocks

Stand-Alone Risk

• Chance of return is < the expected return
• When cash flows are not know with certainty

Answer 2

Stand-alone risk Con’t

Can be measure by:

• Standard deviation (or coefficient of variation) of the project’s profitability (ROI) as measured by NPV, IRR, MIRR
• The larger the Standard deviation the greater the risk
• Only relevant when a not-for-profit is evaluating its first project
  
  • No protfolio diversification is present

Question 3

Corporate Risk:

• A new project’s risk is its contribution to the business’s overall risk
• Measured by Corporate beta
• Standard deviation of the business’s ROE
• Depends on:
  
  • Project’s stand alone risk (Standard deviation)
  • Correlation of the project’s return to the overall returns of the business

Answer 3

Market risk:

• Risk of projects being evaluated by investor-owned businesses
• Risk contribution to the riskiness (Standard deviation) of a well-diversified stock portfolio
• Depends on:
  
  • Project’s stand alone risk (Standard deviation)
  • Correlation of the project’s return to the overall returns of the market portfolio
• Measured by Market beta

Question 4

Sensitivity Analysis

• Shows exactly how much a project’s profitability - NPV, IRR, MIRR - will change in response to a given change in a single input variable with other things held constant

Sensitivity Analysis Steps:

• Base case developed using expected values for all uncertain variables.
• A negative slope indicates that increases in the value of that input variable decreases that project’s NPV
• Profitability break-even information
• Ignores interaction among the input variables

Question 5

Scenario Analysis

• Stand alone risk analysis
• Calculate the expected NPV, IRR, MIRR
• Calculate the Standard deviation of the distribution of the NPVs or IRR or MIRR using the expected return (NPV, IRR, MIRR)
• Standard deviation = square root of variiance or (variance)^1/2
• Calculate the coefficient of variation
  
  • CV = Standard deviation / expected return
• CV is a measure of rick per unit of return
• If the CV of a project is higher than the CV of a average project, the project has an above average risk.

Answer 5

Benefit of the Scenario Analysis

• Provides a quantitative measure
• Provides information about the worst and best possible results
• Considers more than one variable at a time

Limitations of the Scenario Analysis

• Only considers a few states of the economy
• Implies a definite relationship among the variables
• Tends to create extreme profitability values for the worst and best cases

Question 6

Qualitative Questions related to CF uncertainty:

1. Does the project require additional market share or represent a new serivce initiative?
2. Is the current management unqualified for the project?
3. Does it require a technical expert?
4. Are there srong competitiors in the market?
5. Does it need new / unproven technology?

Yes = 1

Score analysis

0 = less than avg. risk, 1 - 2 = avg. risk, 3 or more = avove avg. risk.

Question 7

Incorporating Risk in the decision process:

Two methods:

1. The certainty equivalent method
2. Risk-adjusted discount rate method

1. The certainty equivalent Method

Derived from the economic concept of Utility:

• Evaluate a CF’s risk
• Specify how much money, with certainty, would be required to be indifferent between the riskless sum and the risky sum.
• The greater the degree of risk aversion, the lower the certainty equivalent amount.

Answer 7

2. The Risk Adjusted Discount Rate (RADR)

Project Cost of Capital = Corporate Cost of Capital + Risk Adjustment

• The risk adjustment is made to the discount rate (the opportunity cost of capital).
• All avg. risk projects are discounted at the firm’s corporate cost of capital, above-avg.-risk projects are assigned to a higher cost of capital etc.

Benefits:

• Has a bench mark: The firm’s corporate cost of capital (the riskiness of the business in the aggregate)
• Requires a single adjustment to the cost of capital
• It combines the factors that account for time-value with adjusment for risk
  
  • Compounds risk premium over time
  • Short-term projects look better as compared to long-term projects

Question 8

Adjusting Cash outflows:

1. Applied when two projects will produce the same revenue stream.
2. Make a decisio based on the PV of the expected future costs.
3. Choose the value with the lower NPV
4. Cash outflow that has above-average risk must be evaluated with a lower-than-averge cost of capital.
5. Higher risk –> lower discount rate –> lower NPV

Question 9

Profitability Index of a project =

PV of Cash inflows / PV of Cash outflows

• Measures a project’s dollars profitability per dollar of investment

EX: PI of a project = 1.03

• 3 cents of profit for every dollar invested
• Need to make sure if it is before or after adjusting for risk.