Basic Risk Adjustment Techniques in Capital Budgeting

Basic concept of risk in capital budgeting

Risk analysis should be incorporated in capital budgeting exercise. The capital

budgeting decisions are based on the benefits derived from the project. These benefits
measured in terms of cash flows are estimates. The estimation of future returns is done
on the basis of various assumptions.
The actual return in terms of cash inflows depends on a variety of factors such as price,
sales volume, effectiveness of advertising, competition, cost of raw materials,
manufacturing cost and so on. Each of these in turn, depends on other variables
Likestate of the economy, rate of inflation, etc. The accuracy of the estimates of future
returns and the reliability of the investment decision would largely depend upon the
accuracy with which these factors are forecasted. The actual return will vary from the
estimated return, which is technically referred to as risk.
Thus risk with reference to investment decision is defined as "the variability in actual
returns arise from a project in future over its working life in relation to the estimated
return as forecast at the time of the initial capital budgeting decisions".

Types of Risk
The risk can be broken up into three types:-
Certainty:
It is a situation where the returns are assured and no variability likely to occur in future
returns. For example investment in Government bonds fixed deposits in a nationalized
bank.
Uncertainty:
It is a situation where infinite number of outcomes are possible and probabilities cannot
be assigned. ' ,
Risk:
Risk is the variability that is likely, occur in future returns from the investment. In other
words, risk is a situation in which the probabilities of future cash flows occurring are
known.
Risk Adjustment Techniques in Capital Budgeting

Risk Adjusted Discount rate

The use of risk adjusted discount rate is based on the concept that investors demand
higher return from the risky project. The required rate of return on any investment
should be include compensation for delaying consumption plus compensation for
inflation equal to risk free rate of return plus compensation for any kind of risk taken. If
the risk associated with any investment project is higher than risk involved in a similar
kind of project, discount rate is adjusted upward in order to compensate this additional
risk borne.

According to Besely and Brigham,” The discount rate that applies to a particular risky
stream of income it is equal to the risk-free rate of interest plus a risk premium
appropriate to the level of risk attached to a particular projects income stream.”

In this position, to more risk, to more risk-adjusted discounted rates. (Project's risk ↑ =
RADR's rate ↑)

NCF
NPV=∑ n
−NCO
(1+k )
Where,
NCF= Net Cash Flow
K= Risk adjusted Discount rate
NCO= Net cash outlay/ Initial Investment

A risk adjusted discount rate is a sum of risk free rate and risk premium. The risk
premium depends on the perception of risky by investor of a particular investment and
risk aversion of the investor.

So,Risk adjusted discount rate= risk free rate + risk premium

Risk free rate

It is the rate of return on investments that bear on risk. For e.g., Government securities
yield a return of 6% and bear no risk. In such case, 6% is risk free rate.
Risk Premium
It is the rate of return over and above the risk free rate, expected by investors as a
reward for bearing extra risk. For high project, the risk premium will be high and for
low risk projects, the risk premium would be lower.
Advantages of Risk adjusted Discount rate
 It is easy to understand
 It incorporates risk premium in the discounting factor

Limitations Risk adjusted Discount rate

 Difficulty in finding risk premium and risk adjusted discount rate
 Though NPV can be calculated but it is not possible to calculate standard
deviation of a given projects.

Certainty Equivalent Method

Certainty Equivalent method involve expressing risky future cash flows in terms of the
certain cash flow which would be considered by the decision maker, as their equivalent
that is the decision maker would be indifferent between the risky amount and the
riskless amount considered to be its equivalent.

Certainty Equivalent Factor (CEF) is the ratio of assured cash flows to uncertain cash
flows. Under this approach, the cash flows expected in a project are converted into risk-
less equivalent amount. The adjustment factor used is called CEF. This varies between 0
and 1. A co-efficient of 1 indicates that cash flows are certain. The greater the risk in
cash flow, the smaller will be CEF ‘for receipts’, and larger will be the CEF ‘for
payments’.

Method of Computation under CE approach:

Step 1: Convert uncertain cash flows to certain cash flows by multiplying it with the
CEF.
Step 2: Discount the certain cash flows at the risk free rate to arrive at NPV.

Decision Rule: If the result of NPV is positive project can be accepted.

Advantages of Certainty Equivalent Method

 Certainty Equivalent Method simple and easy to understand and apply.
 It can easily be calculated different risk level applicable to different cash flows.

Limitations of Certainty Equivalent Method

 There is no objective or mathematical method to estimate certainty equivalent.
Certainty equivalents are subjective and vary as per each individual estimate.
 Certainty equivalents are decided by the management based on their perception
of risk. However, the risk perception of the shareholders who are the money
 lenders for the project is ignored. Hence it is not used often in corporate decision
making.

Risk adjusted discounted rate Vs. Certainty equivalent

Certainty Equivalent Method is superior than the risk adjusted discount rate method as
it does not assume that risk increases with time at constant rate. Each year’s
certaintyequivalent coefficient is based on level of risk impacting its cash flow. Despite
its soundness, it is not preferable like risk adjusted discount rate method. It is difficulty
to specify a series of certainty equivalent coefficients but simple to adjust discount rate.

Capital Asset Pricing Model (CAPM)

The Capital Asset Pricing Model (CAPM) describes the association between the
anticipated return and the risks of investing in a security. It represents the fact that the
expected return on an asset is equal to the risk-free return rate plus a premium for
taking the risk that is based on the beta of the security.
Assessing the CAPM requires proper knowledge of systematic and unsystematic risks.
 Systematic risks are the general dangers, which apply to all forms of investment.
For example, inflation rate, Wars, recessions, etc., are systematic risks.
 Unsystematic risks, on the other hand, show the specific dangers associated with
investing in a particular stock or equity. The unsystematic risks are not taken as
threats that are shared by the general market.
CAPM deals with the systematic risks on securities, therefore predicting what could go
wrong with given investments.
Assumptions of CAPM
 The investors are risk-averse
 Choice on the basis of risks and returns
 Similar expectations of risk and return
 Free access to all available information
 There is a risk-free asset and there is no restriction on borrowing and lending at
the risk-free rate
Formula for CAPM

CAPM formula is given by,

E(𝑅)=𝑅𝑓+β×(𝑅𝑚−𝑅𝑓)
The different factors of this equation are −
 E(𝑅) = Expected rate of return from investment
 𝑅𝑓 = Risk-free rate
 β = Beta factor of the underlying transaction
 𝑅𝑚−𝑅𝑓) = Current market risk premium
This CAPM formula takes the returns into accounts, which the investor receives due to
their risk-taking ability and extended duration of the investment. The beta factor here
is calculated as a risk along with the current market conditions.
Therefore, if the risks associated with an investment are lower than the present
circumstances, the beta value of the formula will be less than 1. For the risk that equals
the market conditions, the beta will be equal to 1. Lastly, if the risk is more than the
established market norm, the ‘Be’ value in the formula will be greater than 1.
How does CAPM Benefit Investors?
There are certain advantages of the CAPM model of risk-reward evaluation for
investors.
 Assumption of a diversified portfolio − The CAPM model assumes that an
investor always maintains a diversified investment portfolio, which can eliminate
the unsystematic risks.
 Convenient and simple − This model is built in a way that is extremely easy to
use. The calculations enable investors to decide one way or the other while it
comes to choosing equities.

Drawbacks of CAPM
While CAPM is used by investors worldwide, it does have some drawbacks as well.
 Risk-free rates tend to change frequently − The CAPM considers the short-term
government securities to generate a risk-free premium for the rate used in CAPM
calculations. This risk-free rate, however, is highly volatile, changing within a
span of just a few days.
 A risk-free rate is not a real factor − Individual investors are unable to lend or
borrow at the same rates as the government does. Therefore, assuming a
complete risk-free rate for calculation is not practical. Therefore, the correct
return from an investment may go lower than what is predicted by the CAPM
model.
The arbitrage pricing model (APT)

A substitute and concurrent theory to the Capital Asset Pricing Model (CAPM) is one
that incorporates multiple factors in explaining the movement of asset prices. The
arbitrage pricing model (APT) on the other hand approaches pricing from a different
aspect. It is rarely successful to analyze portfolio risks by assessing the weighted sum
of its components. Equity portfolios are far more diverse and enormously large for
separate component assessment, and the correlation existing between the elements
would make a calculation as such untrue. Rather, the portfolio’s risk should be viewed
as a single product’s innate risk. The APT represents portfolio risk by a factor model
that is linear, where returns are a sum of risk factor returns. Factors may range from
macroeconomic to fundamental market indices weighted by sensitivities to changes in
each factor. These sensitivities are called factor-specific beta coefficients or more
commonly, factor loadings. In addition, the firm-specific or idiosyncratic return is
added as a noise factor. This last part, as is the case with all econometric models, is
indispensable in explaining whatever the original factors failed to include. In contrast
with the CAPM, this is not an equilibrium model; it is not concerned with the efficient
portfolio of the investor. Rather, the APT model calculates asset pricing using the
different factors and assumes that in the case market pricing deviates from the price
suggested by the model, arbitrageurs will make use of the imbalance and veer pricing
back to equilibrium levels. At its simplest form, the arbitrage pricing model can have
one factor only, the market portfolio factor. This form will give similar results to the
Capital Asset Pricing Model (CAPM).

Stephen Ross, who initiated Arbitrage Pricing Theory (APT) in 1976, explained that an
asset’s price today should equal the sum of discounted future cash flows, where the
expected return of the asset is a linear function of the various factors. It is based on the
tenet that in a well-functioning security market no arbitrage opportunities should exist.

The core idea of the APT is that only a small number of systematic influences affect the
long term average returns of securities. The first ingredient of Ross’s APT is a factor
model. Multi-factor models allow an asset to have not just one, but many measures of
systematic risk. Each measure captures the sensitivity of the asset to the corresponding
pervasive factor. If the factor model holds exactly and assets do not have specific risk,
then the law of one price implies that the expected return of any asset is just a linear
function of the other assets’ expected return. If this were not the case, arbitrageurs
would be able to create a long-short trading strategy that would have no initial cost, but
would give positive profits for sure.

According to the above explanation, risky asset return will satisfy the following
equation:
E(rj) = rf + bj1RP1 + bj2RP2 + bj3RP3 + bj4RP4 + … + bjnRPn

Where,

 E(rj) is the expected return of the asset,

 RPn the is risk premium of the factor,
 rf is the risk-free rate
 bn is the sensitivity of the asset to factor n, also known as factor loading.

Major assumptions of Arbitrage Pricing Theory (APT)

 Returns can be described by a factor model,

 There are no arbitrage opportunities,
 There are a large number of securities so it is possible to form portfolios that
diversify the firm-specific risk of individual stocks and
 The financial markets are frictionless.

Factors may be economic factors (such as interest rates, inflation, GDP) financial factors
(market indices, yield curves, exchange rates) fundamentals (like price/earnings ratios,
dividend yields), or statistical (e.g. principal component analysis, factor analysis.) The
factor model’s beta coefficients i.e. sensitivities may be estimated using cross-sectional
regression or time series techniques.

Relationship between CAPM and APT

The two models approach asset pricing from different aspects. The Arbitrage Pricing
Theory (APT) is less restrictive in its assumptions than the Capital Asset Pricing Model
(CAPM). It is a rather explanatory model as opposed to statistical one. It assumes
investors will each hold a portfolio unique to their risk receptiveness with a unique
beta, as opposed to the identical market portfolio presumed by the CAPM.