Capital Budgeting

Introduction and Project Risk

Capital Budgeting Is the process of:

• Measuring• Evaluating• Selecting long-term investment

opportunity

Project Risk

Capital undertakings have elements of both

• Risk

• Reward

Risk: The possibility of loss or other unfavorable

Results that derives from uncertainty

implicitly in future outcomes

11/24/2014 4

Definition of risk

• Incomplete or incorrect analysis of the project,

including failure to incorporate revenue or cost

elements or mis-estimation of those elements.

• Unanticipated actions of customers, suppliers,

and competitors, including changing prices of

resources, and the advent of new technology.

A particular project may be at risk from the following:

• Unanticipated changes in laws, regulations, or

other political changes.

• Unanticipated macroeconomic changes, including

changes in interest rates, inflation/deflation rates,

tax rates, and currency exchange rates.

A particular project may be at risk from the following:

11/24/2014 7

REDUCING RISK

An alternate content page.

11/24/2014 8

WITH A LARGE NUMBER OF DIVERSE PROJECTS, THE UNFAVORABLE OUTCOMES EXPERIENCED BY SOME PROJECTS ARE MORE LIKELY TO BE OFFSET BY FAVORABLE OUTCOMES EXPERIENCED BY OTHER PROJECTS.

In effect, having a diverse portfolio of projects reduces the aggregate risk to the firm in much the same manner that diversification of securities holdings reduces the risk in a securities investment portfolio.

The risk associated with an increase in interest rates would apply similarly to all long-term projects

An unanticipated increase in interest rates would tend to result in lower returns from all long-term projects.

In most cases, risks derived from the macroeconomic environment cannot be reduced by project diversification

Certain Risks are likely to impact most projects in the same manner.

11/24/2014 10

Risk-Reward Relationship

Stage 1

Stage 2

Stage 3Reward:

• The benefit expected

or required from investment of resources in capital

project and other undertakings.

• The relationship between risk And reward that :

The greater the perceived risk,

The greater the expected reward.

11/24/2014 11

The risk-reward relationship

0

1

2

3

4

5

6

Chart Title

Series 1 Series 2 Series 3

The risk-reward relationship is familiar: the greater the perceived risk, the greater the expected reward. Thus, the relationship between risk and reward is positive and can be shown graphically as:

The rate of return earned on a firm's capital projects must be equal or greater than the rate of return required to attract and maintain investors' capital.

The relationship between a firm's capital projects and the firm's capital that funds those projects.

In the U.S. the risk-free rate of return normally is measured by the rates on U.S.

• Treasury securities (bills and notes). paid on these securities

without incurring the risk associated with commercial Investors

or firms could earn the rates securities or with project undertakings.

• The return expected above the risk-free rate, called the risk premium, depends on the perceived risk inherent in an investment opportunity-securities, projects.

11/24/2014 14

Hurdle Rate or Discount rate

The resulting weighted average is the rate of return that a firm must expect to earn on a project it undertakes.

11/24/2014 15

The rate of return expected solely for the deferred current consumption that results from making an investment.

Risk-free rate of return