When analyzing the risk associated with a capital expenditure, it is important to distinguish between the total project risk and the portfolio or beta risk of that investment. By total project risk we mean the chance that a project will perform below expectations —possibly resulting in losses from the project and for the firm. In the worst case, these losses could be so severe as to cause the firm to fail.
In contrast, a project that has a high level of total project risk may not affect the portfolio risk of the firm at all.Consider the case of oil and gas exploration companies. The firms know that any wildcat well they drill will cost about $2 million and have only a 10 percent chance of success. Successful wells produce profits of $24 million. Unsuccessful wells produce no profits at all, and the entire investment will be a loss.
If each firm only drilled one well, there would be a 90 percent chance the firm would fail (the total project risk would be very high). In contrast, if one firm drilled 100 wildcat wells, the risk of failure from all wells would be very low because of the portfolio risk reduction that results from drilling many wells. In this case, the expected return of the firm would be as follows:
This return is achieved with very little risk relative to that facing a firm drilling a single well. As this example illustrates, the risk of drilling any individual well can be diversified away very effectively. Consequently, these risks are not market related, and they should have little, if any, impact on the beta risk of the firm. That risk remains unchanged and approximately equal to the market risk facing other oil and gas exploration companies.
This example has shown that an investment with high total project risk does not necessarily have to possess high beta (systematic) risk. Of course, it is possible for a project to have both high total project risk and high beta risk. For example, a grocery-store chain (which typically has low beta risk) might decide to develop and market a new line of small business computers.
Because of the large number of competitors in this business and because of the grocery chain’s lack of expertise, this investment can be expected to have a high level of total project risk. At the same time, the beta risk of this investment is likely to be high relative to that of the grocery chain, because business computer sales expand rapidly during boom periods and slow down dramatically during recessions.
From a capital budgeting perspective, the beta risk of a project is certainly important because the beta of a firm influences the returns required by investors in that firm and hence the value of the firm’s shares.
Total project risk is also important to consider in most cases for several reasons. There are a number of relatively undiversified investors, including the owners of small firms, for whom total project and total firm risk are important. Also, the total risk of the firm —not just the beta risk —determines the risk of firm failure and potential bankruptcy. Stockholders, creditors, managers, and other employees all are interested in preventing the tragedy (and avoiding the costs) of total firm failure.
Consequently, in the evaluation of an investment project, it is important to consider both the total project risk and the impact of the project on the beta risk of the firm. We continue the chapter with a discussion of a number of techniques that can be used to account for total project risk in the capital budgeting process. In the final section, we examine techniques to use when evaluating the beta risk of a project.
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Financial Management Tutorial
The Role And Objective Of Financial Management
The Domestic And International Financial Marketplace
Evaluation Of Financial Performance
Financial Planning And Forecasting
The Time Value Of Money
Risk And Return On At&t Common Stock
Fixed-income Securities: Characteristics And Valuation
Common Stock: Characteristics,valuation, And Issuance
Capital Budgeting And Cash Flow Analysis
Capital Budgeting: Decision Criteria And Real Option Considerations
Capital Budgeting And Risk
The Cost Of Capital
Capital Structure Concepts
Capital Structure Management In Practice
Working Capital Management
The Management Of Cash And Marketable Securities
Management Of Accounts Receivable And Inventories
Lease And Intermediate-term Financing
Financing With Derivatives
Internationan Financial Management
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