Rather than relate the discount rate—or required return—to the coefficient of variation or possibly the beta, management may wish to set up risk classes based on qualitative considerations. Examples are presented in Table 13-3. Once again we are raising the discount rate to reflect the perceived risk.
Finance in ACTION Managerial Energy: A High-Risk Industry
One industry that affects world economies is energy. This industry includes coal, natural gas, oil, wind, solar, and even the Canadian tar sands. The prices of all these types of energy are important to every person and company that uses electricity, buses, cars, airplanes, trains, plastics, fertilizer, and more. The search for energy sources can be high risk and can result in either large deposits that generate high returns or no returns if nothing is found. Additionally, as companies search for oil in deeper and deeper waters, the technology used is more sophisticated and the chance of a disaster becomes higher. Just ask British Petroleum about the more than $20 billion dollars in fines and claims that it will cost them to settle the Gulf of Mexico Deepwater Horizon rig explosion that occurred in April of 2010. Did they include the potential cost of disasters in their worldwide drilling program?
Besides the risk of a disaster, every producer of energy is affected by the cost of alternative energy sources. For example, the International Energy Agency now predicts that the U.S. will be energy independent by 2020. An article in The Journal of the International Energy Agency made this comment:
Five years ago no one would have been talking about the prospect of U.S. energy independence. But this year, domestic crude oil production should rise by 10%, and within five years the United States is likely to break the record output high reached more than two decades ago, to flirt with the position of top world producer. 5
The amazing part of the story is that new technology, such as horizontal drilling and hydraulic fracturing, has found ways to get more oil and gas out of old deposits and to recover oil and gas from places that were previously unrecoverable. Estimates are that in the last five years, the U.S. has found enough natural gas for 50 years and is still finding more.
Natural gas is priced per one thousand cubic feet of natural gas or by its equivalent, 1 million BTUs (British Thermal Units). The price of natural gas has gone from $12 per thousand cubic feet in 2008, to $6 in 2011, to $2 in 2012, and $2.79 in 2015. Now if anyone could have predicted this price movement, capital budgeting decisions would have been greatly influenced. Go back and read the quote. Five years ago, no one knew that the U.S. would find so much natural gas in the Marcellus Shale of Pennsylvania and West Virginia and other shale formations in Texas, Colorado, North Dakota, and other western states.
Now this should all seem like good news, but environmentalists are worried that these low natural gas prices will set back wind and solar power projects as natural gas is now more cost competitive. This affects the capital budgeting projects for electric utilities and changes the balance between coal-, oil-, and gas-generating plants. It also affects the budding solar industry and companies like General Electric and Siemens that make electric generating wind turbines.
The ability of the United States to become energy independent also has a geopolitical impact as it reduces U.S. dependence on Middle East oil, which at times can be unpredictable and used as a political tool. The newfound sources of oil and gas will reduce some of the uncertainty of supply constraints. At its peak, the U.S. imported $300 billion dollars of oil per year, and so more domestic oil production will help the U.S. reduce its trade imbalance. This will affect the economy and the value of the dollar and other unpredictable benefits and costs.
We have presented an ever-changing picture of energy and its costs, which needs to be forecast by many companies around the world. The point is that even though we can try to put probabilities on potential outcomes, the accuracy of our forecasts is probably not too high. Given the economic interactions of energy on multiple industries, all the consequences are difficult to predict.
5Michael Cohen, IEA Energy, The Journal of the International Energy Agency, © OECD/IEA 2012, Issue 3, p. 18, January 2013.
Table 13-3 Risk categories and associated discount rates
|Low or no risk (repair to old machinery)||6%|
|Moderate risk (new equipment)||8|
|Normal risk (addition to normal product line)||10|
|Risky (new product in related market)||12|
|High risk (completely new market)||16|
|Highest risk (new product in foreign market)||20|
Example—Risk-Adjusted Discount Rate In Chapter 12, we compared two $10,000 investment alternatives and indicated that each had a positive net present value (at a 10 percent cost of capital). The analysis is reproduced in Table 13-4.
Table 13-4 Capital budgeting analysis
Though both proposals are acceptable, if they were mutually exclusive, only Investment B would be undertaken. But what if we add a risk dimension to the problem? Assume Investment A calls for an addition to the normal product line and is assigned a discount rate of 10 percent. Further assume that Investment B represents a new product in a foreign market and must carry a 20 percent discount rate to adjust for the large risk component. As indicated in Table 13-5, our answers are reversed and Investment A is now the only acceptable alternative.
Other methods besides the risk-adjusted discount rate approach are also used to evaluate risk in the capital budgeting process. The spectrum runs from a seat-of-the-pants “executive preference” approach to sophisticated computer-based statistical analysis.
All methods, however, include a common approach—that is, they must recognize the riskiness of a given investment proposal and make an appropriate adjustment for risk.
Table 13-5 Capital budgeting decision adjusted for risk