Lecture Contemporary financial management (9th Edition) - Chapter 10: Capital budgeting and risk. This chapter looks at adjusting a project’s risk level when it has more or less than the firm’s average risk level. | 10 Capital Budgeting and Risk Introduction This chapter looks at adjusting a project’s risk level when it has more or less than the firm’s average risk level. Risk Project risk Project risk is the risk that a project will perform below expectations. Some of the risk can be diversified away. Beta risk Beta risk depends on the risk of the project relative to the market-portfolio. Beta (systematic) risk cannot be diversified away. Capital asset pricing model (CAPM) The CAPM is used to estimate risk-adjusted discount rates for capital budgeting. Information on Risk The Society for Risk Analysis (SRA) Official journal of the SRA is Risk Analysis Adjusting for Beta Risk in Capital Budgeting The beta concept introduced in Chapter 5 for security risk analysis can also be used to determine risk-adjusted discount rates (RADR) for individual capital budgeting projects. This approach is appropriate for a firm whose stock is widely traded and for which there is very little chance of bankruptcy. The probability of bankruptcy is a function of total risk, not just systematic risk. Adjusting for Beta Risk in Capital Budgeting Just as the beta (systematic risk) of a portfolio of securities can be computed as the weighted average of the individual security betas, a firm may be considered as a portfolio of assets, each having its own beta. From this perspective, the systematic risk of the firm is simply the weighted average of the systematic risk of the individual assets. All Equity Case The project’s risk-adjusted discount rate is found with the SML equation: All Equity Case: Example For example, consider the security market line shown in Figure . The firm has a beta of and is financed exclusively with internally generated equity capital. The market risk premium is 7 percent. All Equity Case: Example When considering projects of average risk—that is, projects that are highly correlated with the firm’s returns on its | 10 Capital Budgeting and Risk Introduction This chapter looks at adjusting a project’s risk level when it has more or less than the firm’s average risk level. Risk Project risk Project risk is the risk that a project will perform below expectations. Some of the risk can be diversified away. Beta risk Beta risk depends on the risk of the project relative to the market-portfolio. Beta (systematic) risk cannot be diversified away. Capital asset pricing model (CAPM) The CAPM is used to estimate risk-adjusted discount rates for capital budgeting. Information on Risk The Society for Risk Analysis (SRA) Official journal of the SRA is Risk Analysis Adjusting for Beta Risk in Capital Budgeting The beta concept introduced in Chapter 5 for security risk analysis can also be used to determine risk-adjusted discount rates (RADR) for individual capital budgeting projects. This approach is appropriate for a firm whose stock is widely traded
