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. PMF DISK PMF Tutor A topic covered for this is risk-adjusted discount rates (RADRs). PMF Problem-Solver: Capital Budgeting Techniques This module allows the student to compare the annualized net present value of projects with unequal lives. PMF Templates No spreadsheet templates are provided for this chapter. Study Guide There are no particular Study Guide examples suggested for classroom presentation. 7
Part 3 Long-Term Investment Decisions ANSWERS TO REVIEW QUESTIONS 10-1 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. 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. 10-2 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. 10-3 a. Sensitivity analysis uses a number of possible inputs (cash inflows) to assess their impact on the firm's return (NPV). In capital budgeting, the NPVs are estimated for the pessimistic, most likely, and optimistic cash flow estimates. By subtracting the pessimistic outcome NPV from the optimistic outcome NPV, a range of NPVs can be determined. b. Scenario analysis is used to evaluate the impact on return of simultaneous changes in a number of variables, such as cash inflows, cash outflows, and the cost of capital, resulting from differing assumptions relative to economic and competitive conditions. These return estimates can be used to roughly assess the risk involved with respect to the level of inflation. c.
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