TAILIEUCHUNG - Project Analysis Under Risk
In this chapter, risk is accounted for by (1) applying a discount rate commensurate with the riskiness of the cash flows, and (2), by using a certainty equivalent factor In chapter 8, risk is accounted for by evaluating the project using sensitivity and breakeven analysis. | Ch 7: Project Analysis Under Risk Incorporating Risk Into Project Analysis Through Adjustments To The Discount Rate, and By The Certainty Equivalent Factor. Introduction: What is Risk? Risk is the variation of future expectations around an expected value. Risk is measured as the range of variation around an expected value. Risk and uncertainty are interchangeable words. Where Does Risk Occur? In project analysis, risk is the variation in predicted future cash flows. Handling Risk In chapter 8, risk is accounted for by evaluating the project using sensitivity and breakeven analysis. In this chapter, risk is accounted for by (1) applying a discount rate commensurate with the riskiness of the cash flows, and (2), by using a certainty equivalent factor There are several approaches to handling risk: In chapter 9, risk is accounted for by evaluating the project under simulated cash flow and discount rate scenarios. Using a Risky Discount Rate The structure of the cash flow discounting mechanism for risk is:- The $ amount used for a ‘risky cash flow’ is the expected dollar value for that time period. A ‘risky rate’ is a discount rate calculated to include a risk premium. This rate is known as the RADR, the Risk Adjusted Discount Rate. Defining a Risky Discount Rate Conceptually, a risky discount rate, k, has three components:- A risk-free rate (r), to account for the time value of money An average risk premium (u), to account for the firm’s business risk An additional risk factor (a) , with a positive, zero, or negative value, to account for the risk differential between the project’s risk and the firms’ business risk. Calculating a Risky Discount Rate A risky discount rate is conceptually defined as: k = r + u + a Unfortunately, k, is not easy to estimate. Two approaches to this problem are: 1. Use the firm’s overall Weighted Average Cost of Capital, after tax, as k . The WACC is the overall rate of return required to satisfy all suppliers of .
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