CHAPTER 10
Risk and Refinements
in Capital Budgeting
INSTRUCTOR’S RESOURCES
Overview
Chapters 8 and 9 developed the major decisionmaking 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 riskadjustment techniques are
examined:
certainty equivalents and riskadjusted discount rates.
PMF DISK
PMF Tutor
A topic covered for this is riskadjusted discount rates (RADRs).
PMF ProblemSolver:
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
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LongTerm Investment Decisions
ANSWERS TO REVIEW QUESTIONS
101
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.
102
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.
103
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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 Spring '12
 Ervina
 Accounting

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