The project with the highest anpv is best lg5 explain

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Unformatted text preview: or spreadsheet. The project with the highest ANPV is best. LG5 Explain the role of real options and the objective of, and basic approaches to, project selection under capital rationing. By explicitly recognizing real options—opportunities that are embedded in capital projects and that allow managers to alter their cash flow and risk in a way that affects project acceptability (NPV)—the financial manager can find a project’s strategic NPV. Some of the more common types of real options are abandonment, LG6 452 PART 3 Long-Term Investment Decisions flexibility, growth, and timing options. The strategic NPV explicitly recognizes the value of real options and thereby improves the quality of the capital budgeting decision. Capital rationing exists when firms have more acceptable independent projects than they can fund. Although, in theory, capital rationing should not exist, in practice it commonly occurs. Its objective is to select from all acceptable projects the group that provides the highest overall net present value and does not require more dollars than are budgeted. The two basic approaches for choosing projects under capital rationing are the internal rate of return approach and the net present value approach. The NPV approach better achieves the objective of using the budget to generate the highest present value of inflows. SELF-TEST PROBLEM (Solution in Appendix B) LG4 ST 10–1 Risk-adjusted discount rates CBA Company is considering two mutually exclusive projects, A and B. The following table shows the CAPM-type relationship between a risk index and the required return (RADR) applicable to CBA Company. Risk index Required return (RADR) 0.0 7.0% (risk-free rate, RF) 0.2 8.0 0.4 9.0 0.6 10.0 0.8 11.0 1.0 12.0 1.2 13.0 1.4 14.0 1.6 15.0 1.8 16.0 2.0 17.0 Project data are shown as follows: Project A Project B Initial investment (CF0) $15,000 $20,000 Project life 3 years 3 years Annual cash inflow (CF) $7,000 $10,000 0.4 1.8 Risk index a. Ignoring any differ...
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This document was uploaded on 01/19/2014.

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