Determinants of project risk

We have seen that the company cost of capital is the correct discount rate for projects that have the same risk as the company's existing business, but not for those projects that are safer or riskier than the company's average. How do we know whether a project is unusually risky? Estimating project risk is never going to be an exact science, but here are two things to bear in mind.

First, we saw in Chapter 8 that operating leverage increases the risk of a project. When a large fraction of your costs is fixed, any change in revenues can have a dramatic effect on earnings. Therefore, projects that involve high fixed costs tend to have higher betas.

Second, many people intuitively associate risk with the variability of earnings. But much of this variability reflects diversifiable risk. Lone prospectors in search of gold look forward to extremely uncertain future earnings, but whether they strike it rich is not likely to depend on the performance of the rest of the economy. These investments have a high standard deviation but a low beta.

Brealey-Myers: Fundamentals of Corporate Finance, Third Edition

III. Risk

10. Risk, Return, and Capital Budgeting

© The McGraw-Hill Companies, 2001

Brealey-Myers: Fundamentals of Corporate Finance, Third Edition

finance in action

How High a Hurdle?

It did raise some eyebrows at first. Two months ago, when Aegon, a Dutch life insurer known for taking care of its shareholders, bought Transamerica, a San Francisco-based insurer, Aegon said it was expecting a return of only 9% from the deal, well below the 11% "hurdle rate" it once proclaimed as its benchmark. Had this darling of the stock market betrayed its devoted investors for the sake of an eye-catching deal?

Not at all. Years of falling interest rates and rising equity valuations have shrunk the cost of capital for firms such as Aegon. So companies that regularly adjust the hurdle rates they use to evaluate potential investment projects and acquisitions are not cheating their shareholders. Far from it: they are doing their investors a service. Unfortunately, such firms are rare in Europe. "I don't know many companies at all who lowered their hurdle rates in line with interest rates, so they're all underin-vesting," says Greg Milano, a partner at Stern Stewart, a consultancy that helps companies estimate their cost of capital.

This has a huge impact on corporate strategy. Companies generally make their investment decisions by discounting the net cash flows a project is estimated to gen erate to their present value. If the net present value is positive, the project should make shareholders better off.

Generally speaking, says Paul Gibbs, an analyst at J.P. Morgan, an American bank, finance directors in America often review their hurdle rates; in continental Europe they do so sometimes, and in Britain, rarely. As a result, the Confederation of British Industry, a big-business lobby, worries about underinvestment, and officials at the Bank of England grumble about firms' reluctance to lower hurdles. This reluctance seems surprising, since companies with high hurdle rates will tend to lose out in bidding for business assets or firms. The hurdle rate should reflect not only interest rates but also the riskiness of each individual project. For instance, Siemens, a German industrial giant, last year started assigning a different hurdle rate to each of its 16 businesses, ranging from household appliances to medical equipment and semiconductors. The hurdle rates—from 8% to 11%— are based on the volatility of shares in rival companies in the relevant industry, and are under constant review.

Source: "How High a Hurdle?" The Economist, May 8, 1999, p. 82. © 1999 The Economist Newspaper Group, Inc. Reprinted with permission. Further reproduction prohibited. www.economist.com.

What matters is the strength of the relationship between the firm's earnings and the aggregate earnings of all firms. Thus cyclical businesses, whose revenues and earnings are strongly dependent on the state of the economy, tend to have high betas and a high cost of capital. By contrast, businesses that produce essentials, such as food, beer, and cosmetics, are less affected by the state of the economy. They tend to have low betas and a low cost of capital.

don't add fudge factors to discount rates

Risk to an investor arises because an investment adds to the spread of possible portfolio returns. To a diversified investor, risk is predominantly market risk. But in everyday usage risk simply means "bad outcome." People think of the "risks" of a project as the things that can go wrong. For example,

• A geologist looking for oil worries about the risk of a dry hole.

• A pharmaceutical manufacturer worries about the risk that a new drug which reverses balding may not be approved by the Food and Drug Administration.

• The owner of a hotel in a politically unstable part of the world worries about the political risk of expropriation.

© The McGraw-Hill Companies, 2001 Finance, Third Edition chapter 10 Risk, Return, and Capital Budgeting 307

Managers sometimes add fudge factors to discount rates to account for worries such as these.

This sort of adjustment makes us nervous. First, the bad outcomes we cited appear to reflect diversifiable risks which would not affect the expected rate of return demanded by investors. Second, the need for an adjustment in the discount rate usually arises because managers fail to give bad outcomes their due weight in cash-flow forecasts. They then try to offset that mistake by adding a fudge factor to the discount rate. For example, if a manager is worried about the possibility of a bad outcome such as a dry hole in oil exploration, he or she may reduce the value of the project by using a higher discount rate. This approach is unsound, however. Instead, the possibility of the dry hole should be included in the calculation of the expected cash flows to be derived from the well. Suppose that there is a 50 percent chance of a dry hole and a 50 percent chance that the well will produce oil worth $20 million. Then the expected cash flow is not $20 million but (.5 x 0) + (.5 x 20) = $10 million. You should discount the $10 million expected cash flow at the opportunity cost of capital: it does not make sense to discount the $20 million using a fudged discount rate.

Expected cash-flow forecasts should already reflect the probabilities of all possible outcomes, good and bad. If the cash-flow forecasts are prepared properly, the discount rate should reflect only the market risk of the project. It should not have to be fudged to offset errors or biases in the cash-flow forecast.

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Project Management Made Easy

Project Management Made Easy

What you need to know about… Project Management Made Easy! Project management consists of more than just a large building project and can encompass small projects as well. No matter what the size of your project, you need to have some sort of project management. How you manage your project has everything to do with its outcome.

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