These procedures along with riskadjustment techniques

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Unformatted text preview: procedures, along with riskadjustment techniques, should enable the financial manager to make capital budgeting decisions that are consistent with the firm’s goal of maximizing stock price. CHAPTER 10 Risk and Refinements in Capital Budgeting 451 REVIEW OF LEARNING GOALS Understand the importance of explicitly recognizing risk in the analysis of capital budgeting projects. The cash flows associated with capital budgeting projects typically have different levels of risk, and the acceptance of a project generally affects the firm’s overall risk. Thus it is important to incorporate risk considerations in capital budgeting. Various behavioral approaches can be used to get a “feel” for the level of project risk, whereas other approaches explicitly recognize project risk in the analysis of capital budgeting projects. LG1 Discuss breakeven cash inflow, sensitivity and scenario analysis, and simulation as behavioral approaches for dealing with risk. Risk in capital budgeting is the chance that a project will prove unacceptable or, more formally, the degree of variability of cash flows. Finding the breakeven cash inflow and assessing the probability that it will be realized make up one behavioral approach that is used to assess the chance of success. Sensitivity analysis and scenario analysis are also behavioral approaches for dealing with project risk to capture the variability of cash inflows and NPVs. Simulation is a statistically based approach that results in a probability distribution of project returns. It usually requires a computer and allows the decision maker to understand the risk-return tradeoffs involved in a proposed investment. LG2 Discuss the unique risks that multinational companies face. Although the basic capital budgeting techniques are the same for multinational and purely domestic companies, firms that operate in several countries must also deal with both exchange rate and political risks, tax law differences, transfer pricing, and strategic rather than strictly financial issues....
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