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Review question 101 are most mutually exclusive

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Unformatted text preview: capital budgeting projects. Review Question 10–1 Are most mutually exclusive capital budgeting projects equally risky? How can the acceptance of a project change a firm’s overall risk? TABLE 10.1 Relevant Cash Flows and NPVs for Bennett Company’s Projects Project A Project B $42,000 $45,000 A. Relevant Cash Flows Initial Investment Year Operating cash inflows 1 $14,000 $28,000 2 14,000 12,000 3 14,000 10,000 4 14,000 10,000 5 14,000 10,000 $11,071 $10,924 B. Decision Technique NPV @ 10% cost of capitala aFrom Figure 9.2 on page 402; calculated using a financial calculator. CHAPTER 10 LG2 Risk and Refinements in Capital Budgeting 427 10.2 Behavioral Approaches for Dealing with Risk Behavioral approaches can be used to get a “feel” for the level of project risk, whereas other approaches explicitly recognize project risk. Here we present a few behavioral approaches for dealing with risk in capital budgeting: risk and cash inflows, sensitivity and scenario analysis, and simulation. In a later section, we consider a popular approach that explicitly recognizes risk. Risk and Cash Inflows risk (in capital budgeting) The chance that a project will prove unacceptable or, more formally, the degree of variability of cash flows. EXAMPLE In the context of capital budgeting, the term risk refers to the chance that a project will prove unacceptable—that is, NPV $0 or IRR cost of capital. More formally, risk in capital budgeting is the degree of variability of cash flows. Projects with a small chance of acceptability and a broad range of expected cash flows are more risky than projects that have a high chance of acceptability and a narrow range of expected cash flows. In the conventional capital budgeting projects assumed here, risk stems almost entirely from cash inflows, because the initial investment is generally known with relative certainty. These inflows, of course, derive from a number of variables related to revenues, expenditures, and taxes. Examples include the level of sales, the cost of raw materials, labor rates, utility costs, and...
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