Introduction To Project Risk Analysis

Three separate and distinct types of risk can be identified:

1. Stand-alone risk, which is the project’s risk disregarding the fact that is but one asset within the firm’s portfolio of assets and that the firm is but one stock in a typical investor’s portfolio of stocks. Stand-alone risk is measured by the variability of the project’s expected returns.

2. Corporate, or within-firm, risk, which is the project’s risk to the corporation, giving consideration to the fact that the project represents only one of the firm’s portfolio of assets, hence that some of its risk effects on the firm’s profits will be diversified away. Corporate risk is measured by the project’s impact on uncertainty about the firm’s future earnings.

3. Market, or beta, risk, which is the riskiness of the project as seen by a well-diversified stockholder who recognizes that the project is only one of the firm’s assets and that the firm’s stock is but one small part of the investor’s total portfolio. Market risk is measured by the project’s effect on the firm’s beta coefficient.

As we shall see, a particular project may have high stand-alone risk, yet because of portfolio effects, taking it on may not have much effect on either the firm’s risk or that of its owners.

Taking on a project with a high degree of either stand-alone or corporate risk will not necessarily affect the firm’s beta. However, if the project has highly uncertain returns, and if those returns are highly correlated with returns on the firm’s other assets and with most other assets in the economy, the project will have a high degree of all types of risk. For example, suppose General Motors decides to undertake a major expansion to build electric autos. GM is not sure how its technology will work on a mass production basis, so there are great risks in the venture-its stand-alone risk is high. Management also estimates that the project will do best if the economy is strong, for then people will have more money to spend on the new autos. This means that the project will tend to do well if GM’s profits are highly correlated with those of most other firms, the project’s beta will also be high. Thus, this project will be risky under all three definitions of risk.

Market risk is important because of its effect on a firm’s stock price: Beta affects k, and k affects the stock price. Corporate risk is also important, for these three reasons:

1. Undiversified stockholders, including the owners of small businesses, are more concerned about corporate risk than about market risk.

2. Empirical studies of the determinants of required rates of return (k) generally find that both market and corporate risk affect stock prices. This suggests that investors, even those who are will diversified, consider factors other than market risk when they establish required returns.

3. The firm’s stability is important to its managers, workers, customers, suppliers and creditors, as well as to the community in which it operates. Firms that are in serious danger of bankruptcy, or even of suffering low profits and reduced output, have difficulty attract9ing and retaining good managers and workers. Also both suppliers and customers are reluctant to depend on weak firm’s and such firms have difficulty borrowing money at reasonable interest rates. These factors tend to reduce risky firms profitability and hence their stock prices and this makes corporate risk significant.

For these three reasons, corporate risk is important even if a firm’s stockholders are well diversified.