Incorporating Risk in Capital Budgeting: A Guide to Better Estimations

Understanding the Impact of Risk on Project Valuation

When undertaking capital budgeting for a project, it's crucial to consider the potential risks that could affect the expected cash flows. Let's begin with a basic example to illustrate how risk can influence project valuation.

Case Study: Project JIT's Cash Flow Estimation

Project JIT is expected to generate a single cash flow of $1,000,000 in its first year. Being an average-risk project, we would typically use a discount rate of 10% to calculate its present value. By dividing $1 million by 1.1, we arrive at a present value of $909,100.

However, upon closer examination, it's discovered that the technology developed by Kanban, the company behind Project JIT, is innovative, yet there's a small chance of failure. So, while $1 million remains the most likely outcome, there's a 22% chance the cash flow could be $1.2 million or a 10% chance of no cash flow at all.

Adjusting for Risk in Cash Flow Projections

With this newfound risk, the expected cash flow adjusts to $900,000 from the initial $1 million projection. Using the same 10% discount rate—since the riskiness has already been factored into the cash flows—the present value drops to $818,182 from the previous $909,100.

Risk Incorporation: Cash Flows vs. Discount Rate

Previously, risk was addressed by adjusting the discount rate. But what happens when you modify the estimated cash flows instead?

Suppose management believes the original cash flow estimates are too optimistic, and they decide to reduce the projection by 10%, resulting in a new cash flow of $900,000. Using a 12% discount rate, the present value adjusts from $892,857 to $803,571, showing a 10% correction in line with the cash flow reduction.

Conversely, if we were to increase the discount rate by 10% instead, from 12% to 22%, and apply it to the original $1,000,000 cash flow, the present value would vary significantly across the years, with a much larger impact on the distant future cash flows.

The Certainty Equivalent Method

An alternative approach to risk adjustment in capital budgeting is the certainty equivalent method. This involves converting expected cash flows into risk-free or certain equivalent cash flows, which are then discounted using a risk-free rate.

For instance, a project expecting to generate $100 million annually for three years with a 6% risk-free rate, an 8% market premium, and a 0.75 beta would have a required return of 12%. Discounting the cash flows at this rate provides a present value of $240.2 million.

By converting these uncertain cash flows to certainty equivalents, we reduce the $100 million to reflect the risk, resulting in lower certainty equivalent values. These are then discounted at the risk-free rate to arrive at a present value, which should theoretically match the present value obtained using the risk-adjusted discount rate.

Key Takeaways

• Adjusting cash flows for risk can be more effective than altering the discount rate, especially for distant future cash flows.

• The certainty equivalent method offers an alternative to discounting risky cash flows at a risk-adjusted rate.

• Converting risky cash flows into certainty equivalents reflects the varying levels of risk over time more accurately.

Capital budgeting is a complex process that requires careful consideration of risk. By understanding and applying these concepts of risk adjustment, you'll be better equipped to estimate the true value of a project and make more informed investment decisions.

For a deeper dive into these concepts and detailed examples, watch the full explanation on the original YouTube video here.