322 CHAPTER 8 Cash Flow Estimation and Risk Analysis
These questions do not have easy answers. From a theoretical standpoint, well-
diversified investors should be concerned only with market risk, managers should be
concerned only with stock price maximization, and this should lead to the conclusion
that market (beta) risk ought to be given virtually all the weight in capital budgeting
decisions. However, if investors are not well diversified, if the CAPM does not operate
exactly as theory says it should, or if measurement problems keep managers from hav-
ing confidence in the CAPM approach in capital budgeting, it may be appropriate to
give stand-alone and corporate risk more weight than financial theory suggests. Note
also that the CAPM ignores bankruptcy costs, even though such costs can be substan-
tial, and the probability of bankruptcy depends on a firm’s corporate risk, not on its
beta risk. Therefore, even well-diversified investors should want a firm’s management
to give at least some consideration to a project’s corporate risk instead of concentrat-
ing entirely on market risk.
Although it would be nice to reconcile these problems and to measure project risk
on some absolute scale, the best we can do in practice is to estimate project risk in a
somewhat nebulous, relative sense. For example, we can generally say with a fair de-
gree of confidence that a particular project has more or less stand-alone risk than the
firm’s average project. Then, assuming that stand-alone and corporate risk are highly
correlated (which is typical), the project’s stand-alone risk will be a good measure of
its corporate risk. Finally, assuming that market risk and corporate risk are highly
correlated (as is true for most companies), a project with more corporate risk than av-
erage will also have more market risk, and vice versa for projects with low corporate
risk.^11In theory, should a firm be concerned with stand-alone and corporate risk?
Should the firm be concerned with these risks in practice?
If a project’s stand-alone, corporate, and market risk are highly correlated, would
this make the task of measuring risk easier or harder? Explain.Incorporating Project Risk into Capital Budgeting
As we described in Chapter 6, many firms calculate a cost of capital for each division,
based on the division’s market risk and capital structure. This is the first step toward
incorporating risk analysis into capital budgeting decisions, but it is limited because it
only encompasses market risk. Rather than directly estimating the corporate risk of a
project, the risk management departments at many firms regularly assess the entire
firm’s likelihood of financial distress, based on current and proposed projects.^12 In
other words, they assess a firm’s corporate risk, given its portfolio of projects. This
screening process will identify those projects that significantly increase corporate risk.
Suppose a proposed project doesn’t significantly affect a firm’s likelihood of finan-
cial distress, but it does have greater stand-alone risk than the typical project in a divi-
sion. Two methods are used to incorporate this project risk into capital budgeting. One
is called the certainty equivalentapproach. Here every cash inflow that is not known with
certainty is scaled down, and the riskier the flow, the lower its certainty equivalent
value. Chapter 17 Web Extension explains the certainty equivalent approach in more
detail. The other method, and the one we focus on here, is the risk-adjusted(^11) For example, see M. Chapman Findlay III, Arthur E. Gooding, and Wallace Q. Weaver, Jr., “On the
Relevant Risk for Determining Capital Expenditure Hurdle Rates,” Financial Management,Winter 1976,
9–16.
(^12) These processes also measure the magnitude of the losses, which is often called value at risk.