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571,410
414,720
288,050 Not given
Project B:
(A) Year Expected
Cash Flow 0
1
2
3
4 $1,000,000
500,000
600,000
700,000
800,000 (B)
αt
1.00
.90
.70
.60
.50 (A x B)
(Expected
Cash Flow) x (αt) (TVM Table)
Present Value
Factor at
5% (Rf) Present
Value $1,000,000
450,000
420,000
420,000
400,000 1.000
.952
.907
.864
.823 $1,000,000
428,400
380,940
362,880
329,200 NPVB = $ 501,420 Thus, project A should be selected, as it has a higher NPV. (NPV) Incorporating Risk into
Capital Budgeting
Capital RiskAdjusted Discount Rate How can we adjust this model
to take risk into account?
to
n NPV =
NPV Σ t=1 FCFt
FCF
t
(1 + k)  IO How can we adjust this model
to take risk into account?
to
n NPV =
NPV Σ t=1 FCFt
FCF
t
(1 + k)  IO Adjust the discount rate (k). RiskAdjusted Discount Rate
RiskAdjusted Simply adjust the discount rate (k)
Simply adjust
to reflect higher risk.
to Riskier projects will use higher
Riskier
higher
riskadjusted discount rates.
riskadjusted Calculate NPV using the new riskadjusted discount rate. RiskAdjusted Discount Rate
RiskAdjusted
n NPV = Σ t=1 FCFt
t  IO
(1 + k*) RiskAdjusted Discount Rates
RiskAdjusted How do we determine the
How
appropriate riskadjusted discount
rate (k*) to use?
(k*) Many firms set up risk classes to
Many
risk
categorize different types of
projects.
projects. Risk Classes
Risk
Risk RADR
Risk
Class (k*)
Class
1 12%
12% 2
3
4 14%
16%
16%
24%
24% Project Type
Replace equipment,
Expand current business
Expand
Related new products
Unrelated new products
Research & Development Summary: Steps to capital budgeting
Summary:
1.
2.
3.
4.
5. Estimate CFs (inflows & outflows).
Assess riskiness of CFs.
Determine the appropriate cost of capital.
Find NPV and/or IRR or something else.
Accept if NPV > 0 and/or IRR > WACC. What is Risk and
Risk Management
Risk What is Risk
What Risk exists if there is something you don’t
want to happen – having a chance to
happen!!! What is Risk – Take 2
What The probability that some event wi...
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This document was uploaded on 02/03/2014.
 Spring '14

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