UNCERTAINTY AND RISK IN

CAPITAL BUDGETING

Analyzing Project Risk

Measuring Project Risk
Risk-Adjusted Investment Analyses
Risk Adjustment Practices
Common Errors in Project Risk Assessment

Analyzing Project Risk

Project-Specific Risk : Risk associated with
Projects, impact of cash-flows (Revenue,
Operating Margins, Working Cap), Other Risks
(Location, Quality of Personnel).
Project Risk Diversification: Selection of large number
of projects eliminate the errors of estimation.

Competitive Risk: The revenues are affected

positively or negatively by the actions of
competitors, (price reduction, new product
introduction)

Analyzing Project Risk

Industry -Specific Risk: Variability in Cash flow due to technology
risk , commodity risk and legal risk
Technology Risk
Legal Risk
Commodity Risk

International Risk: Overseas Projects, Exchange rate movements,

political risk
Diversification possible by taking projects in different countries with
uncorrelated currencies movement.
Derivatives can help

Market Risk: Macro Economic factors, Interest rate movements,

inflation,
Non Diversifiable Risk
Derivative Products can help

Summary
Risk

Example

Firm mitigates
by

Investor
mitigates by

Private firm

Project Risk

Estimation
Mistakes, Errors
of product ,
location

Take a large
number of
projects

Hold
diversifiable
portfolio

Should not
matter if firm
takes large
number of
projects

Competitive

Unexpected
moves of
competitor

Acquiring
competitor

Hold
competitors

Will matter

Industry

Changes that
effect all
industry

Diversify in
other sectors

Hold diversified
portfolio

Will matter

International

Currency risk

Invest in
multiple
countries

Hold across
countries

Will matter

Market Risk

Interest rates,

Non
diversifiable

Non
diversifiable

Will Matter

How do we decide the firm

classification based on Risk?
Guess the category of marginal investor
% Institutions % Held by
Holding
Insiders

Marginal
Investor

Category

High

High

Institutional
Investor

Diversified

Low

High

Insider
(Owners)

Undiversified

Low

High

Wealthy
Investors

Diversified

Low

Low

Small Investor

Restricted
Diversification

Measuring Project Risk

Measuring Market Risk
If project risk is constant across the firm
If project risk varies across the firm
Bottom up Beta (Calculate using the comparable
firms (consider operating leverage)
Accounting Beta
Fundamental Beta
(B=.65+.25Co+.09D/E+.54g-.00009TA)
Where Co=Std ofOI/Avg OI)

Risk-Adjusted Investment Analyses

Adjusting Discount Rates
Adjusting Cost of Equity
Project cost of equity =Rf + Project Beta * Rp
If Currency Risk is the priced risk rather than diversifiable risk,
then a currency risk premium can be added.

Adjusting Expected Cash Flows

Subjective and Risk Return Model
Subjective Estimates
Certainty Equivalent: An alternative to subjective estimates is
certainty equivalent approach where by risky cash flows are
stated in terms of the risk-less cash-flows to which they will be
equivalent. Example a risky cash flow 0f RS 150 may be equal
to a risk less cash flow of RS 100.

Risk Adjustment Practices

Kim Crick and Kim (1986) Survey of 320
firms.
Risk Adjustment Technique

No Adjustment is made (14%)

Adjustment is made subjectively (48%)
Certainty Equivalent (7%)
RADR (29%)
Shortening payback (7%)
Others (5%)

Investment Analysis (Inflation)

1+Nominal R=(1+Real R)*(1+Expected Inflation)
E Inflation=(1+NominalTBond)/(1+inf+IndexTbond)-1

Example:

Common Errors in Project Risk

Assessment

Failure to account for risk

Counting the same risk more than once
Applying firms risk profile to projects
Considering diversifiable risk in project
analysis.