Also other benefits such as increased cash greater

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Unformatted text preview: the firm earned a return in excess of that required (IRR k), the value of the firm could be enhanced. Also, other benefits, such as increased cash, greater borrowing capacity, guaranteed availability of raw materials, and so forth, could result from and therefore justify diversification, in spite of any immediate impact on cash flow. Although a strict theoretical view supports the use of a technique that relies on the CAPM framework, the presence of market imperfections causes the market for real corporate assets to be inefficient. The relative inefficiency of this market, coupled with difficulties associated with measurement of nondiversifiable project risk and its relationship to return, tend to favor the use of total risk to evaluate capital budgeting projects. Therefore, the use of total risk as an approximation for the relevant risk does tend to have widespread practical appeal. 440 PART 3 Long-Term Investment Decisions RADRs in Practice Hint The use of risk classes is consistent with the concept that risk-averse investors require a greater return for greater risks. In order to increase shareholders’ wealth— and hence warrant acceptance—risky projects must earn greater returns. EXAMPLE In spite of the appeal of total risk, RADRs are often used in practice. Their popularity stems from two facts: (1) They are consistent with the general disposition of financial decision makers toward rates of return,5 and (2) they are easily estimated and applied. The first reason is clearly a matter of personal preference, but the second is based on the computational convenience and well-developed procedures involved in the use of RADRs. In practice, firms often establish a number of risk classes, with an RADR assigned to each. Each project is then subjectively placed in the appropriate risk class, and the corresponding RADR is used to evaluate it. This is sometimes done on a division-by-division basis, in which case each division has its own set of risk classes and associated RADRs, similar to those for Bennett Company in Table 10.3. The use of divisional costs of capital and associated risk classes enables a large multidivisional firm to incorporate differing levels of divisional risk into...
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