Risk and Capital Budgeting

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FIGURE 1-1 Variability and risk

FIGURE 1-3 Probability distribution with differing degrees of risk

TABLE 1-2 Betas for five-year period (ending January 2003)

FIGURE 1-5 Relationship of risk to discount rate

TABLE 1-3 Risk categories and associated discount rates

TABLE 1-4 Capital budgeting analysis

TABLE 13-5 Capital budgeting decision adjusted for risk

FIGURE 1-7 Simulation flow chart

FIGURE 1-8 Decision trees

TABLE 1-7 Rates of return for Conglomerate, Inc., and two merger candidates

FIGURE 1-11 Risk-return trade-offs

Outline What is Risk? Statistical Measurements of Risk Beta Coefficient of Correlation The Efficient Frontier

What is Risk?

Statistical Measurements of Risk

Beta

Coefficient of Correlation

The Efficient Frontier

What is Risk? Risk means uncertainty about a future outcome Risk varies greatly depending on the investment: – A T-Bill has zero or no risk – A gold-mining expedition in Africa has high risk Most investors and financial managers are risk averse , meaning they don’t like risk

Risk means uncertainty about a future outcome

Risk varies greatly depending on the investment:

– A T-Bill has zero or no risk

– A gold-mining expedition in Africa has high risk

Most investors and financial managers are risk averse , meaning they don’t like risk

Statistical Measurements of Risk Expected Value: – equal to weighted average of outcomes x probabilities Standard Deviation: – measure of dispersion or variability around the expected value – the larger the standard deviation  the greater the risk Coefficient of Variation: – equal to standard deviation / expected value – the larger the coefficient of variation  the greater the risk

Expected Value:

– equal to weighted average of outcomes x probabilities

Standard Deviation:

– measure of dispersion or variability around the expected value

– the larger the standard deviation  the greater the risk

Coefficient of Variation:

– equal to standard deviation / expected value

– the larger the coefficient of variation  the greater the risk

Beta Beta is a statistical measure of volatility It measures how responsive or sensitive a stock is to market movements in general An individual stock’s beta shows how it compares to the market as a whole: beta = 1 means equal risk with the market beta > 1 means more risky than the market beta < 1 means less risky than the market

Beta is a statistical measure of volatility

It measures how responsive or sensitive a stock is to market movements in general

An individual stock’s beta shows how it compares to the market as a whole:

beta = 1 means equal risk with the market

beta > 1 means more risky than the market

beta < 1 means less risky than the market

Coefficient of Correlation Shows the extent of correlation among projects Has a numerical value of between -1 and +1 Its value shows the risk reduction between projects: Negative correlation (-1)  Large risk reduction No correlation (0)  Some risk reduction Positive correlation (+1)  No risk reduction Coefficient of Correlation  Coefficient of Variation

Shows the extent of correlation among projects

Has a numerical value of between -1 and +1

Its value shows the risk reduction between projects:

Negative correlation (-1)  Large risk reduction

No correlation (0)  Some risk reduction

Positive correlation (+1)  No risk reduction

Coefficient of Correlation  Coefficient of Variation

The Efficient Frontier Firm chooses combinations of projects with the best trade-off between risk and return 2 objectives of management: – Achieve the highest possible return at a given risk level – Provide the lowest possible risk at a given return level The Efficient Frontier is the best risk-return line or combination of possibilities Firm must decide where to be on the line (there is no “right” answer)

Firm chooses combinations of projects with the best trade-off between risk and return

2 objectives of management:

– Achieve the highest possible return at a given risk level

– Provide the lowest possible risk at a given return level

The Efficient Frontier is the best risk-return line or combination of possibilities

Firm must decide where to be on the line (there is no “right” answer)

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