Exam 12: Risk and Refinements in Capital Budgeting

Because of the basic mathematics of compounding and discounting, the risk-adjusted discount rate (RADR) approach implicitly assumes that risk is an increasing function of time.

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

Sensitivity analysis is a statistically based approach used in capital budgeting to get a feel for risk by applying 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. -Which project, M or N, would be preferable if both projects were of average risk as the overall firm and Tangshan Mining has a beta of 1.0? (See Table 12.3)

Behavioral approaches for dealing with project risk

Sensitivity analysis is a behavioral approach that uses a number of possible values for a given variable to assess its impact on a firm's return.

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).

Important types of risk in an international capital budgeting context include all of the following EXCEPT

In a capital budgeting context, risk is generally thought of as the chance that NPV and IRR will provide conflicting recommendations to management.

In a capital budgeting context, risk refers to

A market risk-return function is a graphical presentation of the discount rates associated with each level of project risk.

Table 12.4 Johnson Farm Implement is faced with two mutually exclusive projects, P and Q. The following are the data about the two projects. -Which project do you recommend? (See Table 12.4)

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 using the Annualized NPV approach? (See Table 12.6)

Foreign direct investment is the transfer of capital, managerial, and technical assets to a foreign country.

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

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. -Which of the following statements is most correct?

In case of international capital budgeting, a U.S. company can minimize its political risk by creating a joint venture with a competent and well-connected local partner.

Because a business firm can be viewed as a portfolio of assets, it is important that the firm maintain a diversified portfolio of assets.

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 amount by which the required discount rate exceeds the risk-free rate is called