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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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