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L12-ch11 - Chapter 11 11 Capital Budgeting and Risk...

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Click to edit Master subtitle style Chapter 11 Capital Budgeting and Risk Analysis P. 373 - 381 11
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THREE MEASURES OF A Project Standing Alone Risk Risk diversified away within firm as this project is combined with firm’s other projects and assets. Risk diversified away by shareholders as securities are combined to form diversified portfolio. Project’s Contribution- to-Firm Risk Systematic Risk 22
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INCORPORATING RISK INTO CAPITAL BUDGETING 1. Certainty Equivalent Approach - Adjust free cash flows (FCF) 2. Risk-Adjusted Discount Rate Two Approaches NPV = - IO FCF t (1 + t n t= 1 Σ 33
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Adjusts the risky after-tax cash flows to certain cash flows. The idea: 1. Certainty Equivalent Approach Risky Certainty Certain Cash X Equivalent = Cash Flow Factor (a) 44
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Example 1 $1000 x .70 = 1. Certainty Equivalent Approach Risky Certainty Certain Cash X Equivalent = Cash Flow Factor (a) Flow Example 2 $1000 x .90 = $900 The greater the risk associated with a particular cash flow, the smaller the CE factor.
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