INTRODUCTION OF RISK TO CAPITAL BUDGETING
Risk is the uncertainty a!ut a "r!#ect$s %uture "r!&tai'ity(
 The )e*ree !% +ariai'ity !% cash ,!-s(
 
INTRODUCTION OF RISK TO CAPITAL BUDGETING
Fact!rs inc'u)e uncertainty a!ut %uture re+enues/ e0"en)itures an) ta0es(
 
Sensiti+ity Ana'ysis
SENSITI3IT5 ANAL5SIS
 
S"eci%y ase case ase) !n E0"ecte) 3a'ues
S"eci%y a Percent Chan*e ar!un) the e0"ecte) +a'ue !r s"eci%y -!rst an) est +a'ues %!r a key +aria'e( Ca'cu'ate NP3
Re"eat %!r a'' key +aria'es
 
 
IMPLICATIONS ON T2E GI3EN E;AMPLE
E0"resses cash ,!-s in ter.s !% key +aria'es an) ca'cu'ates the c!nse<uences !% .isesti.atin* +a'ues(
Pr!#ect is n!t sure t! ha+e "!siti+e NP3
3ery sensiti+e t! .arket share an) unit "rice
.ay e -!rth-hi'e t! seek %urther in%!r.ati!n a!ut these +aria'es =e(*( .!re research/ "i'!t
 
D!es n!t "r!+i)e a 'ike'y ran*e !% NP3
 
SCENARIO ANAL5SIS
Scenari! ana'ysis is a eha+i!ra' a""r!ach si.i'ar t! sensiti+ity ana'ysis ut is r!a)er in sc!"e(
Measures the sensiti+ity t! chan*es in .!re than !ne !r a'' key +aria'es( F!r e0a."'e > .arket share/ unit "rice/ cash !ut,!-s etc(
 
STEPS IN CONDUCTING SCENARIO ANAL5SIS
I)enti%y key +aria'es
S"eci%y +a'ues !% the +aria'es *i+en cases !% s"eci&c e+ents an) ec!n!.ic c!n)iti!ns(
Ca'cu'ate NP3 acr!ss 3a'ues in each scenari!
 
SCENARIO ANAL5SIS
D!es n!t s"eci%y h!- 'ike'y is the !ccurrence !% any *i+en scenari!(
S"eci&es a ran*e %!r NP3(
 
SIMULATION MODELS
Statistics?ase) eha+i!ra' a""r!ach that a""'ies "re)eter.ine) "r!ai'ity )istriuti!ns an) ran)!. nu.ers t! esti.ate risky !utc!.es(
C!."uter ai)e) si.u'ati!ns can c!nsi)er in&nite nu.er !% c!.inati!ns(
 
MONTE CARLO SIMULATION@ BASIC STEPS M!)e' the "r!#ect@ e0"ress the key
+aria'es an) the e<uati!ns e0"ressin*
these key +aria'es an) the cash ,!-(
S"eci%y the "r!ai'ities: esti.ate the
"r!ai'ity )istriuti!n !% each key +aria'e(
Assi*n nu.ers re,ectin* the "r!ai'ity
)istriuti!ns %!r the key +aria'es(
Si.u'ate the cash ,!-s
INTERNATIONAL RISK CONSIDERATIONS
MNCs %ace risks that are uni<ue t! the internati!na' arena(
7( E0chan*e Rate Risk
( P!'itica' Risk
E;C2ANGE RATE RISK 
Exchange rate risk is the risk that an une0"ecte) chan*e in the e0chan*e rate -i'' re)uce the .arket +a'ue !% a "r!#ect$s cash ,!-s(
D!''ar +a'ue !% Future cash in,!-s .ay e )ra.atica''y a'tere)(
sh!rt ter. ? risk can e hedged y usin* &nancia' instru.ents such as %!rei*n currency %utures an) !"ti!ns(
 
Much har)er t! "r!tect a*ainst
2!st c!untry can '!ck re"atriati!n !r e+en seie assets
 
INTERNATIONAL RISK CONSIDERATIONS =C!nt(
I."act !% TA;ES "ai) t! %!rei*n *!+ern.ents an) the i."act !% these ta0 "ay.ents !n the "arent c!."any
 Trans%er Pricin*@ The "rices that susi)iaries char*e each !ther %!r the *!!)s an) ser+ices tra)e) et-een the.(
 
INTERNATIONAL RISK CONSIDERATIONS =C!nt(
 
Risk?A)#uste) Disc!unt Rates Risk-adjusted discount rates are
rates !% return that .ust e earne) !n *i+en "r!#ects t! c!."ensate the &r.$s !-ners a)e<uate'ythat is/ t! .aintain !r i."r!+e the &r.$s share "rice(
 
 
Insert Fi*ure 78( here
Figure 10.2  CAPM an) SML
 
Bennett C!."any -ishes t! a""'y the Risk-Adjusted Discount Rate
(RADR) a""r!ach t! )eter.ine -hether t! i."'e.ent Pr!#ect A !r
B( In a))iti!n t! the )ata "resente) ear'ier/ Bennett$s
.ana*e.ent assi*ne) a risk in)e0 !% 7( t! "r!#ect A an) 7(8 t!
"r!#ect B as in)icate) in the %!''!-in* ta'e( The re<uire) rates !%
return ass!ciate) -ith these in)e0es are then a""'ie) as the
)isc!unt rates t! the t-! "r!#ects t! )eter.ine NP3(
Risk?A)#uste) Disc!unt Rates@ A""'yin* RADRs
 
 
 
Tale 10.3  Bennett C!."any$s Risk C'asses an) RADRs
 
Risk?A)#ust.ent Techni<ues@ P!rt%!'i! E1ects
As n!te) ear'ier/ in)i+i)ua' in+est!rs .ust h!') )i+ersi&e) "!rt%!'i!s ecause they are n!t re-ar)e) %!r assu.in* )i+ersi&a'e risk(
Because usiness &r.s can e +ie-e) as "!rt%!'i!s !% assets/ it -!u') see. that it is a's! i."!rtant that they t!! h!') )i+ersi&e) "!rt%!'i!s(
Sur"risin*'y/ h!-e+er/ e."irica' e+i)ence su**ests that &r. +a'ue is n!t a1ecte) y )i+ersi&cati!n(
 
Risk?A)#ust.ent Techni<ues@ P!rt%!'i! E1ects =c!nt(
It turns !ut that &r.s are n!t re-ar)e) %!r )i+ersi&cati!n ecause in+est!rs can )! s! the.se'+es(
 
Ca"ita' Bu)*etin* Re&ne.ents@ C!."arin* Pr!#ects 4ith Une<ua' Li+es I% "r!#ects are in)e"en)ent/ c!."arin*
"r!#ects -ith une!ual li"es is n!t critica'(
But -hen une<ua'?'i+e) "r!#ects are mutually exclusi"e/ the i."act !% )i1erin* 'i+es .ust e c!nsi)ere) ecause they )! n!t "r!+i)e ser+ice !+er c!."ara'e ti.e "eri!)s(
 
 The AT C!."any/ a re*i!na' ca'e?T3 &r./ is e+a'uatin* t-! "r!#ects/ ; an) 5( The "r!#ects$ cash ,!-s an) resu'tin* NP3s at a c!st !% ca"ita' !% 789 is *i+en e'!-(
 
 The AT C!."any/ a re*i!na' ca'e?T3 &r./ is e+a'uatin* t-! "r!#ects/ ; an) 5( The "r!#ects$ cash ,!-s an) resu'tin* NP3s at a c!st !% ca"ita' !% 789 is *i+en e'!-(
 
I*n!rin* the )i1erence in their use%u' 'i+es/ !th "r!#ects are acce"ta'e
=ha+e "!siti+e NP3s( Further.!re/ i% the "r!#ects -ere .utua''y
e0c'usi+e/ "r!#ect 5 -!u') e "re%erre) !+er "r!#ect ;( 2!-e+er/ it is
i."!rtant t! rec!*nie that at the en) !% its H year 'i%e/ "r!#ect 5 .ust
e re"'ace)/ !r rene-e)(
A'th!u*h a nu.er !% a""r!aches are a+ai'a'e %!r )ea'in* -ith
une<ua' 'i+es/ -e -i'' "resent the .!st ecient techni<ue ?? the
annua'ie) NP3 a""r!ach(
 
 The ANP3 a""r!ach c!n+erts the NP3 !% une<ua'?'i+e) .utua''y e0c'usi+e "r!#ects int! an e<ui+a'ent =in NP3 ter.s annua' a.!unt that can e use) t! se'ect the est "r!#ect(
1. Calculate the NPV of each project over its live using the appropriate cost of capital.
2. Divide the NPV of each positive NPV project by the PVIF at the given cost of capital and the project!s live to get the NPV for each project.
". #elect the project $ith the highest NPV.
#nnuali$ed %&' (#%&')
 
NPVX = $11,248; NPV Y = $18,985.
2. Calculate the NPV for Projects % and &.
ANPVX = $11,248/PVIFA10%,3 years = $4,523
ANPV Y = $18,985/PVIFA10%,6 years = $4,359
". Choose the project $ith the higher NPV.
Pi! "r#e X.
#nnuali$ed %&' (#%&')
 
Rec!*niin* Rea' O"ti!ns
Real options are !""!rtunities that are e.e))e) in ca"ita' "r!#ects that ena'e .ana*ers t! a'ter their cash ,!-s an) risk in a -ay that a1ects "r!#ect acce"tai'ity =NP3(
Rea' !"ti!ns are a's! s!.eti.es re%erre) t! as strategic options(
 
Tale 10.* Ma#!r Ty"es !% Rea' O"ti!ns
 
projects and * +see ,able 1'.1- finds no real options
e)bedded in Project but t$o real options e)bedded
in *
1. During it!s first t$o years/ * $ould have do$nti)e that
results in unused production capacity that could be used
to perfor) contract )anufacturing0
2. Project *!s co)puteried control syste) could control t$o
other )achines/ thereby reducing labor costs.
%&'strategic + %&'traditional , 'alue o Real ptions
Rec!*niin* Rea' O"ti!ns =c!nt(
 
*ennett!s )anage)ent esti)ated the NPV of the contract )anufacturing
option to be 1/3'' and the NPV of the co)puter control sharing option to
be 2/'''. Further)ore/ they felt there $as a 4'( chance that the
contract )anufacturing option $ould be e5ercised and a "'( chance that
the co)puter control sharing option $ould be e5ercised.
'alue o Real ptions or / + (0 x 1400) ,
(30 x 2000)
  500 , 00 + 1400
o"er /.
 
Ca"ita' Rati!nin*
Fir.$s !%ten !"erate un)er c!n)iti!ns !% capital rationingthey ha+e .!re acce"ta'e in)e"en)ent "r!#ects than they can %un)(
9n theory/ ca"ita' rati!nin* sh!u') n!t e0ist &r.s sh!u') acce"t a'' "r!#ects that ha+e "!siti+e NP3s(
2!-e+er/ research has %!un) that .ana*e.ent interna''y i."!ses ca"ita' e0"en)iture c!nstraints t! a+!i) -hat it )ee.s t! e e0cessi+e 'e+e's !% ne- &nancin*/ "articu'ar'y )et(
 
 Tate C!."any/ a %ast *r!-in* "'astics c!."any -ith a c!st !%
ca"ita' !% 789/ is c!n%r!nte) -ith si0 "r!#ects c!."etin* %!r its
&0e) u)*et !% J8/888( The initia' in+est.ent an) IRR %!r each
"r!#ect are sh!-n e'!-@
Ca"ita' Rati!nin*