Exam 12: Risk and Refinements in Capital Budgeting

International capital budgeting differs from domestic capital budgeting as cash inflows and outflows occur in a foreign currency and foreign investments potentially face significant political risk.

Annualized net present value approach is the most efficient technique for dealing with projects of unequal lives.

________ reflects the return that must be earned on the given project to compensate the firm's owners adequately.

An approach to capital rationing that involves graphing project returns in descending order against the total dollar investment to determine the group of acceptable projects is called the ________.

The risk-adjusted discount rate approach to evaluating projects with unequal lives converts the net present value of unequal-lived, mutually exclusive projects into an equivalent annual amount.

Table 12.5 Nico Manufacturing is considering investment in one of two mutually exclusive projects X and Y which are described below. Nico Manufacturing's overall cost of capital is 15 percent, the market return is 15 percent and the risk-free rate is 5 percent. Nico estimates that the beta for project X is 1.20 and the beta for project Y is 1.40. -What potential biases exist in project selection if Nico Manufacturing did not adjust for the difference in risk between Projects X and Y (See Table 12.5).

For assets traded in an efficient market, the diversifiable risk can be eliminated through diversification.

In applying risk-adjusted discount rates to project selection, projects falling above the SML would have a negative NPV and those falling below the SML would have a positive NPV.

Real options are opportunities that are embedded in capital budgeting projects that enable managers to alter their cash flows and risks in a way that affects project acceptability.

In applying risk-adjusted discount rates to project selection, projects falling above the SML would have a positive NPV and those falling below the SML would have a negative NPV.

Table 12.2 A firm is considering investment in a capital project which is described below. The firm's cost of capital is 18 percent and the risk-free rate is 6 percent. The project has a risk index of 1.5. The firm uses the following equation to determine the risk adjusted discount rate, RADR, for each project: RADR = Rf + Risk Index (Cost of capital - Rf) -The net present value of the project when adjusting for risk is ________. (See Table 12.2)

Sensitivity analysis is a statistics-based approach used in capital budgeting to asses risk by applying predetermined probability distributions and random numbers to estimate risky outcomes.

The importance and widespread use of transfer pricing in international trade makes capital budgeting in MNCs very difficult unless the transfer prices that are used accurately reflect actual costs and incremental cash flows.

Which of the following proposed projects should be accepted for the upcoming year since only $6 million is available for the next year's capital budget. What is the total NPV of the projects that should be accepted?

The risk-adjusted discount rate (RADR) is the rate of return that must be earned on a given project to compensate a firm's owners adequately, that is, to maintain or improve the firm's share price.

The break even cash inflow is the minimum level of cash inflow necessary for a project to be acceptable.

A preferred approach for risk adjustment of capital budgeting cash flows, from a practical viewpoint, is ________.

In capital budgeting, risk refers to ________.

The annualized net present value approach used to evaluate projects with unequal lives converts the net present value of unequal-lived, mutually exclusive projects into an equivalent annual amount.

Table 12.5 Nico Manufacturing is considering investment in one of two mutually exclusive projects X and Y which are described below. Nico Manufacturing's overall cost of capital is 15 percent, the market return is 15 percent and the risk-free rate is 5 percent. Nico estimates that the beta for project X is 1.20 and the beta for project Y is 1.40. -Using the risk-adjusted discount rate method of project evaluation, find the NPV for projects X and Y. Which project should Nico select using this method? (See Table 12.5)