Risk and the Capital Budgeting Process
How can risk analysis be used effectively in the capital budgeting process? In Chapter 12 we made no distinction between risky and nonrisky events.4 We showed the amount of the investment and the annual returns—making no comment about the riskiness or likelihood of achieving these returns. We know that investors and managers care about both risk and expected returns. A $1,400 investment that produces “certain” returns of $600 a year for three years is not the same as a $1,400 investment that produces returns with an expected value of $600 for three years, but with a high coefficient of variation. Investors, being risk-averse by nature, will apply a stiffer test to the second investment. How can this new criterion be applied to the capital budgeting process?
Risk-Adjusted Discount Rate
A favored approach to adjust for risk is to use different discount rates for proposals with different risk levels. Thus we use risk-adjusted discount rates. A project that carries a normal amount of risk and does not change the overall risk composure of the firm should be discounted at the cost of capital. Investments carrying greater than normal risk will be discounted at a higher rate, and so on. In Figure 13-5, we show a possible risk–discount rate trade-off scheme. We assume that risk is measured by the coefficient of variation (V).
Figure 13-5 Relationship of risk to discount rate
The risk of the typical project undertaken by the firm is represented by a coefficient of variation of 0.30 (normal risk) on the bottom of Figure 13-5. An investment with this normal risk would be discounted at the firm’s normal cost of capital of 10 percent. As the firm selects riskier projects, for example, with a V of 0.90, a risk premium of 5 percent is added to compensate for an increase in V of 0.60 (from 0.30 to 0.90). If the company selects a project with a coefficient of variation of 1.20, it will add another 5 percent risk premium for this additional V of 0.30. This is an example of being increasingly risk-averse at higher levels of risk and potential return. Management requires higher expected returns (by using higher discount rates) when the firm is considering projects with higher risks.
Increasing Risk over Time
Our ability to forecast accurately diminishes as we forecast farther out in time. As the time horizon becomes longer, more uncertainty enters the forecast. The decline in oil prices sharply curtailed the search for petroleum and left many drillers in serious financial condition in the 1980s after years of expanding drilling activity. Conversely, the users of petroleum products were hurt in 1990 when the conflict in the Middle East caused oil prices to skyrocket. Airlines and auto manufacturers had to reevaluate decisions made many years ago that were based on more stable energy prices. September 11, 2001, dealt another blow to the already fragile economy. The collapse of the housing market caused a terrible shock to the economy in 2007–2009. The inability of Congress to agree on tax reform and spending cuts lingered throughout Obama’s presidency and caused a great deal of uncertainty for all businesses. Then oil prices again declined from $107 in June 2014 to $53 in July of 2015. These unexpected events create a higher standard deviation in cash flows and increase the risk associated with long-lived projects. Figure 13-6 depicts the relationship between risk and time.
Figure 13-6 Risk over time
Even though a forecast of cash flows shows a constant expected value, Figure 13-6 indicates that the range of outcomes and probabilities increases as we move from year 2 to year 10. The standard deviations increase for each forecast of cash flow. If cash flows were forecast as easily for each period, all distributions would look like the first one for year 2.