Exam 12: Risk and Refinements in Capital Budgeting

The risk-adjusted discount rate can be computed as the risk free rate plus the product of a project's beta and the market return.

Table 12.1 A corporation is assessing the risk of two capital budgeting proposals. The financial analysts have developed pessimistic, most likely, and optimistic estimates of the annual cash inflows which are given in the following table. The firm's cost of capital is 10 percent. -The range of the annual cash inflows for Project A is ________. (See Table 12.1)

Scenario analysis is a statistics-based behavioral approach that applies predetermined probability distributions and random numbers to estimate risky outcomes.

Table 12.3 Tangshan Mining Company is considering investment in one of two mutually exclusive projects M and N which are described below. Tangshan Mining's overall cost of capital is 15 percent, the market return is 15 percent and the risk-free rate is 5 percent. Tangshan estimates that the beta for project M is 1.20 and the beta for project N is 1.40. -Using the risk-adjusted discount rate method of project evaluation, the NPV for project M is ________. (See Table 12.3)

The theoretical basis from which the concept of risk-adjusted discount rates is derived is

The objective of ________ is to select the group of projects that provides the highest overall net present value and does not require more dollars than are budgeted.

In the real world, different projects have different levels of risk. As a result, the acceptance of a particular project generally has an impact on the firm's overall risk, although usually in a minor way (depending on size).

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 discount rate that should be used in the net present value calculation to compensate for risk is ________. (See Table 12.2)

One type of simulation program made popular by the widespread use of personal computers is called

Table 12.3 Tangshan Mining Company is considering investment in one of two mutually exclusive projects M and N which are described below. Tangshan Mining's overall cost of capital is 15 percent, the market return is 15 percent and the risk-free rate is 5 percent. Tangshan estimates that the beta for project M is 1.20 and the beta for project N is 1.40. -Using the risk-adjusted discount rate method of project evaluation, the NPV for project N is ________. (See Table 12.3)

Simulation analysis is a behavioral approach that evaluates the impact on the firm's return of simultaneous changes in a number of variables.

The risk-adjusted discount rate can be computed as the risk free rate plus the product of a project's beta and the market risk premium.

In case of international capital budgeting, long-term currency risk can be minimized by at least partly financing the foreign investment with a dollar-denominated capital contribution from the parent company rather than in the local capital markets.

When unequal-lived projects are independent, the length of the projects' lives is not critical.

Projects with a small chance of being acceptable and a broad range of expected cash flows are more risky than projects having a high chance of being acceptable and a narrow range of expected cash flows.

The objective of capital rationing is to select the group of projects that provides the highest overall net present value and does not require more dollars than are budgeted.

A firm is evaluating two mutually exclusive projects that have unequal lives. The firm must evaluate the projects using the annualized net present value approach and recommend which project they should select. The firm's cost of capital has been determined to be 14 percent, and the projects have the following initial investments and cash flows:

The danger that an unexpected change in the exchange rate between the dollar and the currency in which a project's cash flows are denominated can increase the market value of that project's cash flow.

A behavioral approach that evaluates the impact on the firm's return of simultaneous changes in a number of project variables is called

The risk-adjusted discount rate (RADR) is the risk-adjustment factor that represents the percent of estimated cash inflows that investors would be satisfied to receive for certain rather than the cash inflows that are possible for each year.