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Lg3 describe the determination and use of risklg4

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Unformatted text preview: LG3 Describe the determination and use of riskLG4 adjusted discount rates (RADRs), portfolio effects, and the practical aspects of RADRs. The risk of a project whose initial investment is known with certainty is embodied in the present value of its cash inflows, using NPV. Two opportunities to adjust the present value of cash inflows for risk exist—adjust the cash inflows or adjust the discount rate. Because adjusting the cash inflows is highly subjective, adjusting discount rates is more popular. The RADRs use a market-based adjustment of the discount rate to calculate NPV. The RADR is closely linked to CAPM, but because real corporate assets are generally not traded in an efficient market, the CAPM cannot be applied directly to capital budgeting. Instead, firms develop some CAPM-type of relationship to link a project’s risk to its required return, which is used as the discount rate. Often, for convenience, firms will rely on total risk as an approximation for relevant risk when estimating required project returns. RADRs are commonly used in practice, because decision makers prefer rates of return and find them easy to estimate and apply. Recognize the problem caused by unequallived mutually exclusive projects and the use of annualized net present values (ANPVs) to resolve it. The problem in comparing unequal-lived mutually exclusive projects is that the projects do not provide service over comparable time periods. The annualized net present value (ANPV) approach is the most efficient method of comparing ongoing mutually exclusive projects that have unequal usable lives. It converts the NPV of each unequallived project into an equivalent annual amount—its ANPV. The ANPV can be calculated using financial tables by dividing each project’s NPV by the present value interest factor for an annuity at the given cost of capital and project life. Alternatively, it can be calculated using a financial calculator— the keystrokes are identical to those used to find the annual payment on an installment loan—...
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