Exam 12: Risk and Refinements in Capital Budgeting

Even though a business firms can be viewed as a portfolio of assets, firms are not rewarded for selecting a diversified portfolio of assets because investors can more efficiently diversify away unsystematic risk on their own.

In the real world, different projects have different levels of risk. As a result, the acceptance of a particular project usually has an enormous impact on the firm's overall risk.

The ________ reflects the return that must be earned on the given project to compensate the firm's owners adequately according to the project's variability of cash flows.

When unequal-lived projects are independent, the impact of differing lives must be considered because the projects do not provide service over comparable time periods.

The risk-adjusted discount rate is the rate of return that a project must earn to maintain or improve the firm's share price.

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

All projects should always use the WACC as the required return for capital budgeting purposes.

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 better investment for Tangshan Mining is ________. (See Table 12.3)

In case of unequal-lived, mutually exclusive projects, the use of net present value to select the better project could result in an incorrect decision.

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. -Calculate the risk-adjusted discount rates for project X and project Y. (See Table 12.5)

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

In a capital budgeting context, risk is the chance that a project will prove unacceptable or, more formally, the degree of variability of cash flows.

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)

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)

The higher the risk of a project, the higher its risk-adjusted discount rate and thus the lower the net present value for a given stream of cash inflows.

Table 12.6 Yong Importers, an Asian import company, is evaluating two mutually exclusive projects, A and B. The relevant cash flows for each project are given in the table below. The cost of capital for use in evaluating each of these equally risky projects is 10 percent. -Which project should be chosen on the basis of the normal NPV approach? (See Table 12.6)

Tangshan Mining Company, with a cost of capital of 10 percent, is considering investing in project A, with an initial investment of $1,000,000. Project A is expected to provide equal cash inflows over its 15 year useful life. Based on this information, the breakeven cash inflow for the project is

Risk-adjusted discount rates (RADRs) are the risk-adjustment factors that represent 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.

Calculate the NPV of projects X and Y assuming that the firm did not employ the RADR method and instead used the firm's overall cost of capital to evaluate projects X and Y. (See Table 12.5)

Table 12.6 Yong Importers, an Asian import company, is evaluating two mutually exclusive projects, A and B. The relevant cash flows for each project are given in the table below. The cost of capital for use in evaluating each of these equally risky projects is 10 percent. -The NPVs of projects A and B are ________. (See Table 12.6)