0321286618_10 - Chapter 10 Risk and Refinements in Capital...

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Chapter 10 Risk and Refinements in Capital Budgeting Instructor’s Resources Overview Chapters 8 and 9 developed the major decision-making aspects of capital budgeting. Cash flows and budgeting models have been integrated and discussed in providing the principles of capital budgeting. However, there are more complex issues beyond those presented. Chapter 10 expands capital budgeting to consider risk with such methods as sensitivity analysis, scenario analysis, and simulation. Capital budgeting techniques used to evaluate international projects, as well as the special risks multinational companies face, are also presented. Additionally, two basic risk-adjustment techniques are examined: certainty equivalents and risk-adjusted discount rates. Study Guide There are no particular Study Guide examples suggested for classroom presentation. Suggested Answer to Chapter Opening Critical Thinking Question Why might the industries mentioned in this vignette be more likely to use risk simulation programs than other industries? Some companies are more closely associated with risk factors than others. Companies with an international scope pick up a currency risk which domestic companies do not have. Insurance companies deal specifically in the business of risk management. Other companies, such as energy companies, deal with a commodity known for its fluctuations in supply and demand. When a business deals in risk management, a risk simulation program would naturally become an important tool for financial managers. Answers to Review Questions 1. There is usually a significant degree of uncertainty associated with capital budgeting projects. There is the usual business risk along with the fact that future cash flows are an estimate and do not represent exact values. The uncertainly of each project is cash flow will be different and thus each project has its own unique risk. This uncertainty exists for both independent and mutually exclusive projects. The risk associated with any single project has the capability to change the entire risk of the firm. The firm’s assets are like a portfolio of assets. If an accepted capital budgeting project has a risk different from the average risk of the assets in the firm, it will cause a shift in the overall risk of the firm.
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253 Part 3 Long-Term Investment Decisions 2. Risk , in terms of cash inflows from a project, is the variability of expected cash flows, hence the expected returns, of the given project. The breakeven cash inflow the level of cash inflow necessary in order for the project to be acceptable may be compared with the probability of that inflow occurring. When comparing two projects with the same breakeven cash inflows, the project with the higher probability of occurrence is less risky.
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0321286618_10 - Chapter 10 Risk and Refinements in Capital...

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