PART 3: CAPITAL BUDGETING
11-1d THE RISK-ADJUSTED DISCOUNT RATE AND COST
OF CAPITALThe general principle we are following in this section is to describe how we may adjust the discount
rate to accommodate perceived varying levels of risk associated with the investments of interest to us. A
simple way for us to do this, based on the ideas about CAPM outlined in earlier chapters, would seem
to be to add a risk premium to some market-based required return where the risk premium reflects the
risks of the project. This concept is sometimes referred to as the risk-adjusted discount rate (RADR). The
case study at the end of Part III (see page 429) addresses this approach.
We should note, however, that there are several issues we need to consider with this approach. First, the
idea gives us no concept of the size of the risk premium to add: we need further theory to be confident that we
would be adding an appropriate risk premium associated with the project. The CAPM is one such method for
adjusting the required rate of return to allow for the relative risk of an investment compared with a ‘market’ rate.
There are variants of this, using methods developed by Stephen Ross (the ‘arbitrage pricing theory’) and Eugene
Fama and Kenneth French (the ‘three-factor’ model). These all provide consistent approaches to developing a
risk-adjusted return, starting with the risk-free rate of return and adding to it various premia for risks.
Second, embedded in these approaches in a recognition that the risk adjustments are those associated with
market factors for a well-diversified set of investors. None uses the unique, specific or idiosyncratic risk linked
to a particular project. It is the risk associated with a class of investment – shares, bonds, projects undertaken
by groups of companies in the market – that is providing the risk premium added to the risk-free rate.
Third, if we do adopt the approach of adding a single risk premium to an existing risk-free rate
intended to capture the risk profile of an investment, we are implicitly assuming that the risk remains the
same for all future periods in the life of the investment, and a constant discount rate is to be used. This
means the impact of the discounting is growing in a non-linear fashion over time, with proportionately
greater discounting occurring each period into the future. This may be appropriate for some investments,
if we feel the long-term future is much less certain than the short-term future; but not all investments are
of this nature. For example, pharmaceutical companies that must put their new drugs through sequences
of clinical trials actually become more confident about their products’ success if they survive the early
trials. The risk of the drug actually declines with more success in future clinical trials.11-2 A CLOSER LOOK AT RISK
Thus far, the only consideration we have given to risk in our capital budgeting analysis is selecting the right
discount rate. But it would be simplistic to say that, given a stream of cash flows, an analyst’s work is done
after she has discounted those cash flows using a risk-adjusted discount rate to determine the NPV. Managers
generally want to know more about a project than just its NPV. They want to know the sources of uncertainty
and the downside risk, as well as the quantitative importance of each source. Managers need this information to
decide whether a project requires additional analysis, such as market research or product testing. Managers also
want to identify a project’s key value drivers, so they can closely monitor them after an investment is made. Next,
we explore techniques that give managers deeper insights into the uncertainty structure of capital investments.11-2a BREAKEVEN ANALYSIS
When companies make investments, they do so with the objective of earning a profit. But another objective
that sometimes enters the decision process is avoiding losses. Therefore, managers often want to know what isLO11.3