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Learning Goals

• LG 1 Understand the importance of recognizing risk in the analysis of capital budgeting projects.
• LG 2 Discuss risk and cash inflows, scenario analysis, and simulation as behavioral approaches for dealing with risk.
• LG 3 Review the unique risks that multinational companies face.
• LG 4 Describe the determination and use of risk-adjusted discount rates (RADRs), portfolio effects, and the practical aspects of RADRs.
• LG 5 Select the best of a group of unequal-lived, mutually exclusive projects using annualized net present values (ANPVs).
• LG 6 Explain the role of real options and the objective and procedures for selecting projects under capital rationing.

Why This Chapter Matters to You

In your professional life

ACCOUNTING You need to understand the risk caused by the variability of cash flows, how to compare projects with unequal lives, and how to measure project returns when capital is being rationed.

INFORMATION SYSTEMS You need to understand how risk is incorporated into capital budgeting techniques and how those techniques may be refined in the face of special circumstances so as to design decision modules for use in analyzing proposed capital projects.

MANAGEMENT You need to understand behavioral approaches for dealing with risk, including international risk, in capital budgeting decisions; how to risk-adjust discount rates; how to refine capital budgeting techniques when projects have unequal lives or when capital must be rationed; and how to recognize real options embedded in capital projects.

MARKETING You need to understand how the risk of proposed projects is measured in capital budgeting, how projects with unequal lives will be evaluated, how to recognize and treat real options embedded in proposed projects, and how projects will be evaluated when capital must be rationed.

OPERATIONS You need to understand how proposals for the acquisition of new equipment and plants will be evaluated by the firm’s decision makers, especially projects that are risky, have unequal lives, or may need to be abandoned or slowed, or when capital is limited.

In your personal life

Risk is present in all long-term decisions. When making personal financial decisions, you should consider risk in the decision-making process. Simply put, you should demand higher returns for greater risk. Failing to incorporate risk into your financial decision-making process will likely result in poor decisions and reduced wealth.

YPF Argentina Seizes Oil Company from Spanish Owners

YPF is the largest oil company in Argentina. After operating for more than 70 years as a state-owned enterprise, YPF was privatized in 1993 and later purchased by the Spanish firm, Repsol S.A. In the purchase agreement, the government of Argentina retained a “golden share,” essentially giving the government the right to outvote all other shareholders on certain matters.

After Repsol’s acquisition of YPF, the Argentinian company’s production faltered. In 2011, Argentina reported a deficit in international energy trade for the first time in almost 15 years (meaning that it imported more energy than it exported). Government officials began to point fingers at Repsol, accusing the company of mismanaging YPF and underinvesting in exploration and production in Argentina. Governors in several provinces revoked Repsol’s leases, an action that contributed to a 50% decline in YPF shares from February to early April. Finally, on April 16, 2012, Argentina’s president, Cristina Kirchner, announced that her country would sieze a majority state in YPF from Repsol, essentially expropriating the firm’s assets from Repsol. Repsol would receive some compensation in exchange for their YPF shares, but company officials insisted that the compensation they were offered was far below the value of the assets that had been seized.

A little more than a year later, Chevron Corp. announced that it would fund most of a $1.5 billion joint venture with YPF to develop the country’s shale oil and gas deposits. Commentators noted that in making such a large investment in Argentina, Chevron was demonstrating its willingness to take on not only the inherent risks associated with oil and gas exploration, but also the political risks of doing business in Argentina.

When firms undertake major investments, they cannot avoid taking risks. These risks may arise from the nature of the business that a company operates in, such as the risks of oil exploration, but political factors can also create risks that may diminish the value of a company’s investments. This chapter focuses on the tools available to managers that help them better understand the risks of major investments.