Finance 4333

Risk & Capital Budgeting

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 Risk and Return
• Before continuing our capital budgeting
discussion, let’s briefly review risk and return
• Stock return analysis easily lends itself to this
discussion
• Recall the return formula:
– Return = (Price Change + Income)/(Initial Price)

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 Standard Deviation and Expected Value
•• Sticking
  with stock returns:
• Average returns (Arithmetic mean):
– Average is same thing as expected value

– Arithmetic mean vs. Geometric mean

• Volatility of returns – measure of risk
– Sample Variance
– Standard Deviation is square root of Variance
– Sample vs. Population calculation
• Examples
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 Capital Budgeting under Uncertainty

• Up until now: We’ve assumed we could perfectly estimate future

CFs and their underlying components
• But what if we are uncertain about future CF components (and thus
the CFs themselves)?
– Simulation is a useful tool
• Simulation
– Randomly pick values for CF components, then compute project CFs and
NPV
– Repeat many times, giving us a distribution of NPVs
• Allowing us to compute the expected value for NPV (mean) and project risk (NPV
standard deviation)
• Simplifying assumption: Key CF components follow a normal
distribution

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Normal Distribution

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 Normal Distribution: Excel Functions

• NORM.DIST function: For our purposes, gives the

probability that a variable will be less than or equal to
a given number

• NORM.INV function: Returns the value associated with

a given probability

• Need to have an estimate of the variable’s mean and

standard deviation and assume the variable follows a
normal distribution
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 Exercise 1
• Use the function NORM.INV () and run 200 trials of a normal
distribution with a mean of 2 and a standard deviation of 1.
Use the random number generator RAND () to generate
random probabilities for the NORM.INV function.

• Use the FREQUENCY function to count the number of

observations within various ranges of values (or BINs). To
execute the FREQUENCY function, we need to highlight the
column to the right of the BINs and then enter the
FREQUENCY formula. Once finished entering the formula, do
not hit Enter; rather we need to enter CTRL + SHIFT + ENTER.

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 Exercise 1 Continued
• Create a frequency distribution (column chart)
• Different methods for creating the chart:
• One general option:
– Go to Insert, and then choose one of the Column Chart choices
– Click Select Data (under Design ribbon)
– Click Add under Legend Entries (Series), delete any values in Series Values, and then
select range of values desired for y-axis (Frequency column). Click Ok
– Click Edit under Horizontal (Category) Axis Labels, and then select range of values
desired for x-axis (Bin column). Click Ok.
• Another way to create the same chart
– Highlight the Frequency column
– Go to Insert, and then choose the Column Chart. Choose the first 2D option
– Add BINs to the horizontal axis:
• Right click in the chart area, click on Select Data, click the Edit button under the
Horizontal (Category) Axis Labels, highlight the Bin column, and click OK.

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 Exercise 2
• You are considering a project with the following information: Sales for the first year
will be $500, but the sales in subsequent years are uncertain. The sales growth rate
is estimated to be distributed normally with a mean of 2% and a standard
deviation of 0.50%. Variable costs each year are uncertain as well, but are
assumed to be a percentage of sales. The variable cost percentage follows a
normal distribution with mean of 30% of sales and standard deviation of 2% of
sales each year.

• Fixed costs are $200 per year, while NWC is 10% of sales each year. The project will
require an initial investment in NWC of $40. The entire NWC investment (across all
years) will be recovered the final year. To operate the project, a new piece of
equipment must be purchased at a cost of $400. The equipment will be
depreciated using a MACRS schedule. The equipment will have no salvage value.

• The cost of capital for the project is 12%. The tax rate is 40%.

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 Exercise 2 Continued
• Set up a spreadsheet that will calculate the NPV of the project
while capturing the uncertainty in sales and variable expenses.

• Simulate the NPV 1000 times using a data table.

– Create a data table like we normally do. But this time, the column input
is any blank cell, instead of a specific cell with input data.

• Graph the distribution of the NPV; calculate the mean NPV and
standard deviation.

• Calculate the probability that the project will have a positive NPV.

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