Risky Projects

Knut P. Heen PhD

Associate Professor
Molde University College
Road Map
Based on HGT chapter 11
The Risk-Adjusted Discount Rate Method
Tracking Portfolio and Tracking Error
From Tracking to Discounting
Comparable Investments and Leverage
Potential Pitfalls
The Certainty Equivalent Method
Essentially a Two-Step Procedure of the Above

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Two Methods
The risk-adjusted discount rate method (standard)
Forecast expected cash flows
Discount with risk-adjusted discount rate

Certainty equivalent method (alternative)

Forecast risk-adjusted cash flows
Discount with the risk-free rate

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The Risk-Adjusted Discount Rate
Method
Tracking portfolio approach
Find portfolio which tracks project cash flows (CAPM or APT)
Present value of cash flows = value of tracking portfolio

Tracking error
Risky projects → tracking error (imperfect tracking)
Problem if tracking error contains systematic risk

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Hilton Hotels Example (p. 351)

Cash Flows
State Probability Hilton Hotels Market Portfolio
Good 0.4 12,3 mill 1,4
Average 0.4 11,3 mill 1,2
Bad 0.2 9,3 mill 0,8

Risk-free rate 0,06

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Hilton Hotels Example cont’d
Tracking portfolio
$5 million in risk-free → $5.3 million

$5 million in market portfolio

Present value of project is $10 million
50 percent in risk-free
50 percent in market portfolio

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Tracking Error Example

Cash Flows
State Probability Hilton Hotels Market Portfolio
Good 0.4 12,4 mill 1,4
Average 0.4 11,2 mill 1,2
Bad 0.2 9,3 mill 0,8

Risk-free rate 0,06

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Tracking Error Example cont’d
Tracking portfolio
As before (50/50 risk-free/market)

Tracking error
State Probability Project Portfolio Error
Good 0,4 $12,4 $12,3 -$0,1
Average 0,4 $11,2 $11,3 +$0,1
Bad 0,2 $9,3 $9,3 $0

Expected error

Not a problem if expected error is unsystematic

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From Tracking to Discounting
Hilton CAPM tracking portfolio
CAPM portfolio consist of
Weight 1-β in risk-free asset (50 percent)
Weight β in the market portfolio (50 percent)
Hilton project β is therefore 0.5
Market return:
Cash flow:
Discounted cash flow

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Present Value of Future Risky CFs
Risk-Adjusted Discount Rate Method
Find expected cash flow, E(CF)
Find project beta, β(s) (tracking portfolio)
Find expected return on tracking portfolio
Discount E(CF) with return on tracking portfolio

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How to Find Project Beta?
Usually through “comparable” investments
A new project is obviously not traded in the market already
Comparable real projects are usually not traded either
Securities of firms owning comparable projects are, however, traded
Use these to estimate project beta (industry/sector beta)
We will come back to some pitfalls later

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The Effect of Leverage
Balance sheet
Real Assets, A Debt, D
Equity, E

Accounting identity
Value of equity & debt must equal value of assets

Risk-free debt
Implies that all risk is borne by equityholders

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Equity Beta
Volatility of equity

Beta

Note that risky debt has

Expected return

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Expected Return & Leverage
r

rE

rA

rD

D/E

pdefault = 0 pdefault > 0

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Implementation
Don’t forget
Comparable firms should have comparable assets
But comparable firms may have different leverage

Implication
Must de-lever βE/rE of comparable firms (find rA)

Weighting of comparable firms

Often good idea to use a value-weighted β
Be careful with observations of highly levered firms

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Potential Pitfalls
Project beta vs. firm beta
Not necessarily identical (fixed costs → operating leverage)
Growth opportunities
Options are levered-equity → growth options have high betas

Firm beta will be an average beta of AIP and GO

Multi-period discounting
Using the same discount rate for every cash flow
Long-term rf or short-term rf?
Time-varying beta?

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CAPM vs. APT
Largely a matter of belief (at this point)
All the same mathematical rules apply to APT as well

You will, of course, come up with different PVs/NPVs with the two
methods

Problem with APT

People may choose factors to produce high PVs
Not as easy to misuse the CAPM (you are married to the market
portfolio)

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The Certainty Equivalent Method
Approach
Risk-adjust cash flows directly → certainty equivalent, CE
Discount the certainty equivalent cash flow with risk-free rate

How to compute CE?

Find cash flow beta (amount invested in tangent portfolio)

Compute CE(CF) and PV(CF)

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The Hilton Example
Recall
Expected cash flow was $11.3 million
Amount invested in the market portfolio was $5 million
Certainty equivalent:
Present value:

Conclusion
A two-step procedure which is equivalent with risk-adjusted discount
rate method

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When is the CE-Method Useful?
Some situations
When it is more convenient to obtain the cash flow beta (b) than the
return beta (β)
When finding “comparable” investments is difficult
Convenient in scenario-analysis (the Hilton example)
When forward prices are available
Forward prices are certainty equivalents

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