Assume that the management of bennett company decided

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Unformatted text preview: the capital budgeting process and still recognize differences in the levels of individual project risk. Assume that the management of Bennett Company decided to use risk classes to analyze projects and so placed each project in one of four risk classes according to its perceived risk. The classes ranged from I for the lowest-risk projects to IV for the highest-risk projects. Associated with each class was an RADR appropriate to the level of risk of projects in the class, as given in Table 10.3. Bennett classified as lower-risk those projects that tend to involve routine replacement or TABLE 10.3 Risk class I Bennett Company’s Risk Classes and RADRs Description Below-average risk: Projects with low risk. Typically involve routine replacement without renewal of existing activities. Risk-adjusted discount rate, RADR 8% II Average risk: Projects similar to those currently implemented. Typically involve replacement or renewal of existing activities. 10%a III Above-average risk: Projects with higher than normal, but not excessive, risk. Typically involve expansion of existing or similar activities. 14% IV Highest risk: Projects with very high risk. Typically involve expansion into new or unfamiliar activities. 20% aThis RADR is actually the firm’s cost of capital, which is discussed in detail in Chapter 11. It represents the firm’s required return on its existing portfolio of projects, which is assumed to be unchanged with acceptance of the “average risk” project. 5. Recall that although NPV was the theoretically preferred evaluation technique, IRR was more popular in actual business practice because of the general preference of businesspeople for rates of return rather than pure dollar returns. The popularity of RADRs is therefore consistent with the preference for IRR over NPV. CHAPTER 10 Risk and Refinements in Capital Budgeting 441 renewal activities; higher-risk projects involve expansion, often into new or unfamiliar activities. The financial manager of Bennett has assigned project A to class III and project B to class II. The cash flows for p...
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