Financial Economics

26

EVALUATING PROJECT RISK IN CAPITAL BUDGETING

As explained in the previous chapter, capital budgeting decisions require management to evaluate each project's future cash flows, their riskiness, and their present value. Managers incorporate risk into their calculations in one of two equivalent approaches: (1) a risk-adjusted discount rate approach, or (2) a certainty-equivalent approach. The latter can be calculated either on an ad hoc basis or under a risk-neutral probability measure that provides a theoretical rationale for determining market value, which is after all a particular form of certainty-equivalent value.

Regardless of the method of estimation, the hurdle that management must overcome in arriving at a certainty-equivalent value involves evaluating project riskiness. To assess the risk of a project, management must first recognize that the firm's existing assets are the result of prior investment decisions, and that the firm is really a portfolio of projects. So when management adds another project to its portfolio, it should consider both the risk of that additional project and the risk of the entire portfolio when the new project is included in it. However, despite its correctness, the portfolio theoretic approach is not always easy to implement in practice, and in applications the focus is frequently on the risk of the individual project.

In this chapter, we look at different techniques for assessing a project's risk. Although the techniques are helpful to management ...