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Unformatted text preview: ). The model factors in
elements of economic and political risk to obtain the country’s risk premium and develops betas
for each country on the basis of the local market’s volatility and its correlation to the U.S. market.
For example, the high volatility of Brazil’s market has a low correlation to the U.S. market, so the
country beta was .81. With the risk-free rates and country betas, Bestfoods could calculate local
and global costs of capital.
This more sophisticated approach gave Bestfoods the confidence to pursue an aggressive
international strategy that increased shareholder value and resulted in Unilever offering a substantial premium to acquire the company. In this chapter we’ll look at other techniques that companies use to incorporate risk into the capital budgeting process. W 425 426 PART 3 LG1 Long-Term Investment Decisions 10.1 Introduction to Risk in Capital Budgeting
The capital budgeting techniques introduced in Chapter 9 were applied in an
environment we assumed to be certain. All of the projects’ relevant cash flows,
developed using techniques presented in Chapter 8, were assumed to have the
same level of risk as the firm. In other words, all mutually exclusive projects were
equally risky, and the acceptance of any project would not change the firm’s overall risk. In actuality, these situations are rare—project cash flows typically have
different levels of risk, and the acceptance of a project generally does affect the
firm’s overall risk, though often in a minor way. We begin this chapter by relaxing the assumptions of a certain environment and equal-risk projects, in order to
focus on the incorporation of risk into the capital budgeting decision process.
For convenience, in this chapter, we continue the Bennett Company example
that was used in Chapter 9. The relevant cash flows and NPVs for Bennett Company’s two mutually exclusive projects—A and B—are summarized in Table 10.1.
In the following three sections, we use the basic risk concepts presented in
Chapter 5 to demonstrate behavioral approaches for dealing with risk, international risk considerations, and the use of risk-adjusted discount rates to explicitly
recognize risk in the analysis of...
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This document was uploaded on 01/19/2014.
- Fall '13