Evaluation of Combinations
The firm should evaluate all possible combinations of projects, determining which will provide the best trade-off between risk and return. In Figure 13-10, we see a number of alternatives that might be available to a given firm. Each point represents a combination of different possible investments. For example, point F might represent a semiconductor manufacturer combining three different types of semiconductors, plus two types of computers, and two products in unrelated fields. In choosing between the various points or combinations, management should have two primary objectives:
1. Achieve the highest possible return at a given risk level.
2. Provide the lowest possible risk at a given return level.
Figure 13-10 Risk-return trade-offs
All the best opportunities will fall along the leftmost sector of the diagram (line C–F–G). Each point on the line satisfies the two objectives of the firm. Any point to the right is less desirable.
After we have developed our best risk-return line, known in the financial literature as the “efficient frontier,” we must determine where on the line our firm should be. There is no universally correct answer. To the extent we are willing to take large risks for superior returns, we will opt for some point on the upper portion of the line—such as G. However, a more conservative selection might be C.
The Share Price Effect
The firm must be sensitive to the wishes and demands of shareholders. To the extent that unnecessary or undesirable risks are taken, a higher discount rate and lower valuation may be assigned to the stock in the market. Higher profits, resulting from risky ventures, could have a result that is the opposite from that intended. In raising the firm’s risk, we could be lowering the overall valuation of the firm.
The aversion of investors to nonpredictability (and the associated risk) is confirmed by observing the relative valuation given to cyclical stocks versus highly predictable growth stocks in the market. Metals, autos, and housing stocks generally trade at an earnings multiplier well below that for industries with level, predictable performances, such as drugs, soft drinks, and even alcohol or cigarettes. Each company must carefully analyze its own situation to determine the appropriate trade-off between risk and return. The changing desires and objectives of investors tend to make the task somewhat more difficult.
Risk may be defined as the potential variability of the outcomes from an investment. The less predictable the outcomes, the greater is the risk. Both management and investors tend to be risk-averse—that is, all things being equal, they would prefer to take less risk, rather than greater risk.
The most commonly employed method to adjust for risk in the capital budgeting process is to alter the discount rate based on the perceived risk level. High-risk projects will carry a risk premium, producing a discount rate well in excess of the cost of capital.
In assessing the risk components in a given project, management may rely on simulation techniques to generate probabilities of possible outcomes and decision trees to help isolate the key variables to be evaluated.
Management must consider not only the risk inherent in a given project, but also the impact of a new project on the overall risk of the firm (the portfolio effect). Negatively correlated projects have the most favorable effect on smoothing business cycle fluctuations. The firm may wish to consider all combinations and variations of possible projects and to select only those that provide a total risk-return trade-off consistent with its goals.
REVIEW OF FORMULAS
|P||is probability of outcome|
|is expected value|
|P||is probability of outcome|
|σ||is standard deviation|
|is expected value|
LIST OF TERMS
expected value 421
standard deviation 421
coefficient of variation 422
risk-adjusted discount rates 424
decision trees 428
portfolio effect 430
coefficient of correlation 431
efficient frontier 435
1. If corporate managers are risk-averse, does this mean they will not take risks? Explain. (LO13-2)
2. Discuss the concept of risk and how it might be measured. (LO13-1)
3. When is the coefficient of variation a better measure of risk than the standard deviation? (LO13-1)
4. Explain how the concept of risk can be incorporated into the capital budgeting process. (LO13-3)
5. If risk is to be analyzed in a qualitative way, place the following investment decisions in order from the lowest risk to the highest risk: (LO13-1)
a. New equipment.
b. New market.
c. Repair of old machinery.
d. New product in a foreign market.
e. New product in a related market.
f. Addition to a new product line.
6. Assume a company, correlated with the economy, is evaluating six projects, of which two are positively correlated with the economy, two are negatively correlated, and two are not correlated with it at all. Which two projects would it select to minimize the company’s overall risk? (LO13-5)
7. Assume a firm has several hundred possible investments and that it wants to analyze the risk-return trade-off for portfolios of 20 projects. How should it proceed with the evaluation? (LO13-5)
8. Explain the effect of the risk-return trade-off on the market value of common stock. (LO13-3)
9. What is the purpose of using simulation analysis? (LO13-4)