Chapter 12 Cash Flow Estimation and Risk Analysis 375Three separate and distinct types of risk are involved:- Stand-alone risk, which is a project’s risk assuming (a) that it is the only asset
the " rm has and (b) that the " rm is the only stock in each investor’s portfolio.
Stand-alone risk is measured by the variability of the project’s expected
returns. Diversi" cation is totally ignored. - Corporate, or within-" rm, risk, which is a project’s risk to the corporation as
opposed to its investors. Within-" rm risk takes account of the fact that the
project is only one asset in the " rm’s portfolio of assets; hence, some of its
risk will be eliminated by diversi" cation within the " rm. This type of risk is
measured by the project’s impact on uncertainty about the " rm’s future
returns. - Market, or beta, risk, which is the riskiness of the project as seen by a well-
diversi" ed stockholder who recognizes (a) that the project is only one of the
" rm’s assets and (b) that the " rm’s stock is but one part of his or her stock
portfolio. The project’s market risk is measured by its effect on the " rm’s beta
coef" cient.
Taking on a project with a great deal of stand-alone or corporate risk will not
necessarily affect the " rm’s beta. However, if the project has high stand-alone
risk and if its returns are highly correlated with returns on the " rm’s other
assets and with returns on most other stocks in the economy, the project will
have a high degree of all three types of risk. Market risk is theoretically the
most relevant of the three because it is the one re! ected in stock prices. Unfor-
tunately, market risk is also the most dif" cult to estimate, primarily because
new projects don’t have “market prices” that can be related to stock market
returns. Therefore, most decision makers do a quantitative analysis of stand-
alone risk and then consider the other two risk measures in a qualitative
manner.
Projects are generally classi" ed into several categories. Then with the " rm’s
overall WACC as a starting point, a risk-adjusted cost of capital is assigned to
each category. For example, a " rm might establish three risk classes, assign the
corporate WACC to average-risk projects, add a 5% risk premium for higher-risk
projects, and subtract 2% for low-risk projects. Under this setup, if the company’s
overall WACC was 10%, 10% would be used to evaluate average-risk projects, 15%
for high-risk projects, and 8% for low-risk projects. While this approach is prob-
ably better than not making any risk adjustments, these adjustments are highly
subjective and dif" cult to justify. Unfortunately, there’s no perfect way to specify
how high or low the adjustments should be.^5
Stand-Alone Risk
The risk an asset would
have if it were a firm’s only
asset and if investors
owned only one stock. It is
measured by the
variability of the asset’s
expected returns.Stand-Alone Risk
The risk an asset would
have if it were a firm’s only
asset and if investors
owned only one stock. It is
measured by the
variability of the asset’s
expected returns.
Corporate (Within-
Firm) Risk
Risk considering the firm’s
diversification but not
stockholder diversification.
It is measured by a
project’s effect on
uncertainty about the
firm’s expected future
returns.Corporate (Within-
Firm) Risk
Risk considering the firm’s
diversification but not
stockholder diversification.
It is measured by a
project’s effect on
uncertainty about the
firm’s expected future
returns.
Market (Beta) Risk
Considers both firm and
stockholder diversification.
It is measured by the
project’s beta coefficient.Market (Beta) Risk
Considers both firm and
stockholder diversification.
It is measured by the
project’s beta coefficient.Risk-Adjusted Cost
of Capital
The cost of capital
appropriate for a given
project, given the riskiness
of that project. The greater
the risk, the higher the cost
of capital.Risk-Adjusted Cost
of Capital
The cost of capital
appropriate for a given
project, given the riskiness
of that project. The greater
the risk, the higher the cost
of capital.(^5) We should note that the CAPM approach can be used for projects provided there are specialized publicly traded
! rms in the same business as that of the project under consideration. For further information on estimating the
risk-adjusted cost of capital, see Web Appendix 12C; and for more information on measuring market (or beta) risk,
see Web Appendix 12D.
SEL
F^ TEST What are the three types of project risk?
Which type is theoretically the most relevant? Why?
What is one classi" cation scheme that " rms often use to obtain risk-adjusted
costs of capital?