Custom Search

Capital Budgeting and Project Risk

COMPANY VERSUS PROJECT RISK

Long before the development of modern theories linking risk and return, smart financial managers adjusted for risk in capital budgeting. They realized intuitively that, other things equal, risky projects are less desirable than safe ones and must provide higher rates of return. Many companies estimate the rate of return required by investors in their securities and use this company cost of capital to discount the cash flows on all new projects.

Since investors require a higher rate of return from a risky company, risky firms will have a higher company cost of capital and will set a higher discount rate for their new investment opportunities. For example, we showed in Table 4.9 that on past evidence Merck has a beta of .92 and the corresponding expected rate of return (see Table 4.10) is about 13 percent. According to the company cost of capital rule, Merck should use a

13 percent cost of capital to calculate project NPVs.

This is a step in the right direction, but we must take care when the firm has issued securities other than equity. Moreover, this approach can get a firm in trouble if its new projects do not have the same risk as its existing business. Merck`s beta reflects investors` estimate of the risk of the pharmaceutical business and its company cost of capital is the return that investors require for taking on this risk. If Merck is considering an expansion of its regular business, it makes sense to discount the forecast cash flows by the company cost of capital. But suppose that Merck is wondering whether to branch out into production of computer hardware. Its beta tells us nothing about the project cost of capital. That depends on the risk of the hardware business and the return that shareholders require from investing in such a business.

The project cost of capital depends on the use to which that capital is put. Therefore, it depends on the risk of the project and not on the risk of the company. If a company invests in a low-risk project, it should discount the cash flows at a correspondingly low cost of capital. If it invests in a high-risk project, those cash flows should be discounted at a high cost of capital.

The nearby box discusses how companies decide on the discount rate. It notes, for example, that Siemens, a German industrial giant, uses 16 different discount rates, depending on the riskiness of each line of its business.

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 earlier 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.

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.

PROJECT COST OF CAPITAL Minimum acceptable expected rate of return on a project given its risk.

COMPANY COST OF CAPITAL Expected rate of return demanded by investors in a company, determined by the average risk of the company`s assets and operations.

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% БІАААм hurdle rateБІАААн 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. БІАААм I don`t know many companies at all who lowered their hurdle rates in line with interest rates, so they`re all underinvesting,БІАААн 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 generate 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 bigbusiness 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 ratesБІАААд from 8% to 11%БІАААд are based on the volatility of shares in rival companies in the relevant industry, and are under constant review.