This preview shows page 1. Sign up to view the full content.
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...
View Full Document
- Fall '13