Risk and Capital Budgeting

LEARNING OBJECTIVES

Nobody understands the meaning of risk better than Apache Corp., a firm that drills for natural gas and oil on properties in the United States, Canada, Australia, Egypt, and the North Sea.

Over the last 20 years, the price of oil has vacillated from less than $11 per barrel to over $145 per barrel. Natural gas has been even more volatile. What appears to be a great opportunity for drilling and discovery when energy prices are at their peak can turn out to be a disaster when those prices drop by 25 to 50 percent or more.1 An even greater threat to Apache Corp. is the proverbial “dry hole,” in which millions of dollars are spent only to discover that there is no oil to be found.

Energy producers such as Apache Corp. are much more vulnerable to changing circumstances in the market than fully integrated oil companies such as ExxonMobil, which not only drills for oil and gas, but refines it and sells it at the retail level through its service stations. For ExxonMobile, lower profits at the discovery level are often offset by higher profits at the retail level and vice versa.

But the upside for oil producers such as Apache Corp. is enormous when they discover oil and gas in a previously untested area. The risk and rewards of this business exceed those in almost any other.

In this chapter, we examine definitions of risk, its measurement and its incorporation into the capital budgeting process, and the basic tenets of portfolio theory.

Definition of Risk in Capital Budgeting

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Risk may be defined in terms of the variability of possible outcomes from a given investment. If funds are invested in a 30-day U.S. government obligation, the outcome is certain and there is no variability—hence no risk. If we invest the same funds in a deep-sea oil drilling venture above the Arctic Circle, the variability of possible outcomes is great and we say the project is extremely risky.

Risk is measured not only in terms of losses but also in terms of uncertainty.2 We say gold mining carries a high degree of risk not just because you may lose your money but also because there is a wide range of possible outcomes. Observe in Figure 13-1 examples of three investments with different risk characteristics.

In each case, the distributions are centered on the same expected value of $20,000, but the variability (risk) increases as we move from Investment A to Investment C. Because you may gain or lose the most in Investment C, it is clearly the riskiest of the three.

Figure 13-1 Variability and risk

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The Concept of Risk-Averse

A basic assumption in financial theory is that most investors and managers are risk-averse—that is, for a given situation they would prefer relative certainty to uncertainty. In Figure 13-1, they would prefer Investment A over Investments B and C, although all three investments have the same expected value of $20,000. You are probably risk-averse too. Assume you have saved $1,000 toward your last year in college and are challenged to flip a coin, double or nothing. Heads, you end up with $2,000; tails, you are broke. Given that you are not enrolled at the University of Nevada at Las Vegas or that you are not an inveterate gambler, you will probably stay with your certain $1,000.

This is not to say investors or businesspeople are unwilling to take risks—but rather that they will require a higher expected value or return for risky investments. In Figure 13-2, we compare a low-risk proposal with an expected value of $20,000 to a high-risk proposal with an expected value of $30,000. The higher expected return may compensate the investor for absorbing greater risk.

Figure 13-2 Risk-return trade-off

Actual Measurement of Risk

A number of basic statistical devices may be used to measure the extent of risk inherent in any given situation. Assume we are examining an investment with the possible outcomes and probability of outcomes shown in Table 13-1.