CHAPTER 11Risk Analysis and the Optimal Capital Budget

11/19/97

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Table of Contents

CHAPTER 11Risk Analysis and the Optimal Capital Budget

What does “risk” meanin capital budgeting?

Is risk analysis based on historical data or subjective judgment?

What three types of risk are relevant in capital budgeting?

How is each type of risk measured, and how do they relate to one another?

How is each type of risk used?

What is sensitivity analysis?

Results of Sensitivity Analysis

What are the weaknesses of sensitivity analysis?

Why is sensitivity analysis useful?

What is scenario analysis?

Assume we know with certainty all variables except unit sales, which could range from 900 to 1,600.

If the firm’s average project has a CV of 0.2 to 0.4, is this a high-risk project? What type of risk is being measured?

Would a project in a firm’s core business likely be highly correlated with the firm’s other assets?

How do correlation and ? combine to affect a project’s contribution to corporate risk?

Would a core project in the furniture business be highly correlated with the general economy and thus with the “market”?

Would correlation with the economy affect market risk?

With a 3% risk adjustment, should our project be accepted?

Should subjective risk factors be considered?

What is a simulation analysis?

What are the advantages of simulation analysis?

What are the disadvantages of simulation?

Find the project’s market risk and cost of capital based on the CAPM.

How does the project’s market risk compare with the firm’s overall market risk?

Is the project’s relative market risk consistent with its stand-alone risk?

Methods for estimating a project’s beta

Advantages and disadvantages of applying the CAPM in capital budgeting

Evaluating Risky Outflows

Now suppose Plan W is riskier than Plan C because future wage rates are difficult to forecast. Would this affect the choice?

Part 2: The Optimal Capital Budget

Calculate WACC, then plot IOS and MCC schedules.

What corporate cost of capital do we use for capital budgeting, i.e., for calculating NPV?

If all 5 projects are average risk, what’s the optimal capital budget?

Suppose you aren’t sure of Corporate k. At what k would B and B* have the same NPV?

Author: Vickie Bajtelsmit