6 the npv of project a at 14 was calculated in figure

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Unformatted text preview: roject A would be evaluated using a 14% RADR, and project B’s would be evaluated using a 10% RADR.6 The NPV of project A at 14% was calculated in Figure 10.3 to be $6,063, and the NPV for project B at a 10% RADR was shown in Table 10.1 to be $10,924. Clearly, with RADRs based on the use of risk classes, project B is preferred over project A. As noted earlier, this result is contrary to the preferences shown in Table 10.1, where differing risks of projects A and B were not taken into account. Review Questions 10–5 Describe the basic procedures involved in using risk-adjusted discount rates (RADRs). How is this approach related to the capital asset pricing model (CAPM)? 10–6 Explain why a firm whose stock is actively traded in the securities markets need not concern itself with diversification. In spite of this, how is the risk of capital budgeting projects frequently measured? Why? 10–7 How are risk classes often used to apply RADRs? LG5 LG6 10.5 Capital Budgeting Refinements Refinements must often be made in the analysis of capital budgeting projects to accommodate special circumstances. These adjustments permit the relaxation of certain simplifying assumptions presented earlier. Three areas in which special forms of analysis are frequently needed are (1) comparison of mutually exclusive projects having unequal lives, (2) recognition of real options, and (3) capital rationing caused by a binding budget constraint. Comparing Projects with Unequal Lives The financial manager must often select the best of a group of unequal-lived projects. If the projects are independent, the length of the project lives is not critical. But when unequal-lived projects are mutually exclusive, the impact of differing lives must be considered because the projects do not provide service over comparable time periods. This is especially important when continuing service is needed from the project under consideration. The discussions that follow assume that the unequal-lived, mutually exclusive pr...
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