Stand-Alone versus Market Risk If we have some idea of the uncertainty associated with a project’s

Stand-Alone versus Market Risk If we have some idea of the uncertainty associated with a project’s

future cash flows—its possible outcomes—and the probabilities associ- ated with these outcomes, we will have a measure of the risk of the project. But this is the project’s risk in isolation from the firm’s other projects, also referred to as the project’s total risk, or stand-alone risk.

Because most firms have many assets, the stand-alone risk of a project under consideration may not be the relevant risk for analyzing

LONG-TERM INVESTMENT DECISIONS

the project. A firm is a portfolio of assets, and the returns of these dif- ferent assets are not perfectly positively correlated with one another. We are therefore not concerned about the stand-alone risk of a project, but rather how the addition of the project to the firm’s portfolio of assets changes the risk of the firm’s portfolio.

Now let’s take it a step further. Shareholders own shares of many firms and these shareholders are investors who themselves may hold diversified portfolios. These investors are concerned about how the firm’s investments affect the risk of their own personal portfolios. When owners demand compensation for risk, they are requiring compensation for market risk, the risk they can’t get rid of by diversifying. Recogniz- ing this, a firm considering taking on a new project should be concerned with how it changes its market risk. Therefore, if the firm’s owners hold diversified investments, it is the project’s market risk that is relevant to the firm’s decision making.

If the Microsoft Corporation introduces a new operating system, the relevant risk to consider in evaluating this new product is not its stand-alone risk, but rather it market risk. Microsoft has many com- puter software products and services—they have a portfolio of invest- ments. And while its investments are all related somewhat to computers, the products’ fortunes do not rise and fall perfectly in sync with one another—in other words, some of the risk is diversified away. Addition- ally, investors who hold Microsoft common stock in their portfolios also own stock of other corporations (and perhaps own some bonds, real estate, or cash). What risk is relevant for Microsoft to consider in its decision regarding the new product? It is the market risk of the prod- uct since some risk is diversified away at the company level and some risk is diversified away at the investors’ level.

Even though we generally believe that it’s the project’s market risk that is important to analyze, stand-alone risk should not be ignored. If we are making decisions for a small, closely-held firm whose owners do not hold well-diversified portfolios, the stand-alone risk gives us a good idea of the project’s risk. And many small businesses fit into this category.

And even if we are making investment decisions for large corpora- tions that have many products and whose owners are well-diversified, the analysis of stand-alone risk is useful. Stand-alone risk is often closely related to market risk: In many cases, projects with higher stand- alone risk may also have higher market risk. And a project’s stand-alone risk is easier to measure than its market risk. We can get an idea of a project’s stand-alone risk by evaluating the project’s future cash flows using statistical measures, sensitivity analysis, and simulation analysis. We now consider these evaluation techniques.

Capital Budgeting and Risk