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spreadsheet. The project with the highest ANPV
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
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.
- Fall '13