Matakuliah : A0774/Information Technology Capital
Budgeting
Tahun
: 2009
Capital Budgeting and Risk
Pertemuan 11-12
Risk
• Risk is to be distinguished from uncertainty
– Uncertainty refers to a situation wherein the decision maker is not able
to predict the possible outcome of his proposed decision.
– Probability distribution of outcomes is unknowns.
• In normal terms, the risk associated with a project may be defined
as the variability that is likely to occur in the future returns from the
project.
– The greater the variability of future returns of a project, the riskier the
project.
Types of project risks
(1) Stand alone risk
which views the risk of a project in isolation
(2) Corporate risk
which views the risk of a project within the context of
firm’s combination of project.
Risk of Different Types of Projects
• A riskier project should promise a higher return to prompt its
acceptance
• The decision maker aims at identifying different types of risk to
which projects are subject to, so that differential risk allowances may
be determined which would reduce all such projects to a common
basis.
• The compilation of differential risk allowances is a subjective
judgment.
Risk of Different Types of Projects
(A)Cost Saving Investments
–Those which apply to established operations
–Those which apply to planned operation
For an investment relating to established operation, operation will continue
regardless of investment as there will be a continuous demand for the product
or services of the proposed investment. This reduces the risks associated with
such an investment.
Risk of Different Types of Projects
(B) Replacement Investments
– Replacement investment are often akin to cost saving
investments in that where they form part of larger continuing
projects
– They do not add to the firm’s main risks.
– Therefore, replacement will be justified whenever the projected
return exceeds the firm’s cost of capital by quite a small margin
Risk of Different Types of Projects
(C) Expansion Investment
– Project designed to expand a firm’s markets are often the riskiest
projects.
– Such investment involve intensive and costly advertising,
development and test marketing.
– The loss can be substantial if the product fails to gain significant
share of the market.
Risk of Different Types of Projects
(D) Investments Required by Regulations
– Most firms will be required to undertake some investments
because these are required by government regulations and
enactments.
• The provision of effluent treatment plant, dust
control equipment, fire fighting equipment, etc., fall
into these categories.
Risk of Different Types of Projects
(E) Amenity Investments
– Firms generally undertake welfare amenity investments of some
kind.
• These may range from the provision of canteens
and rest rooms to sport and social clubs.
– These investments are aimed at boosting employee morale and
commitment.
Measurement of Risk
• Probability distributions
– A probability distribution is defined as a set of possible
outcomes, with a probability of occurrence attached to each
outcome.
• The standard deviation
– A measure of a project’s riskiness is particularly clear is
particularly clear if we assume that the probability distribution
involved is of the type described as normal.
Measurement of Risk
(A)
Project Variance (Independence of Cash Flows)
•
(B)
With independence of cash flows over time, there is no causative
relationship between cash flows from period to period.
Project Variance (Dependence of Cash Flows)
•
The variance of a project whose net cash flows are interdependent is
made up of two components:
(i) The sum of variances of net cash flows for each period
(ii) Co-variance’s representing interrelationship between net
cash flows of different periods.
Approaches to Risk Adjustment
(a) Expected Net Present Value (ENPV)
The concept of expected NPV may be used for project appraisal
in an uncertain world because world because it provides an
average value of the proposed project’s performance.
(b) Payback Method
Payback method represents a traditional way of
assessing investment projects under risk conditions.
Approaches to Risk Adjustment
(c) Adjustments in the Discount Rate
to use a risk-adjusted discount rate for investment appraisal, the company
simply adds to the current risk free rate an additional premium, the of which
is arbitrarily determined by the estimated riskiness of the project being
evaluated.
(d) Use of Normal Distribution
the approach starts from the premise that if a project’s risk can be defined
as the degree of possible variability between its expected outcome and its
actual outcome, then what would be of interest to the decision maker is the
probability of the project actually producing a positive net present value
Approaches to Risk Adjustment
(e) Sensitivity Analysis
it is a widely used approach to the problem of
uncertainty. It is concerned with judging the sensitivity of
items of data which are needed to make a decision.
Approaches to Risk Adjustment
A capital investment simulation model generally considers the following
variables in deriving an investment’s earnings stream :
1. Market size
2. Selling price
3. Market growth rate
4. Share of market
5. Investment required
6. Residual value of investment
7. Operating costs
8. Fixed costs
9. Economic life of investment