**Unformatted text preview: **00
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 Risk-Adjusted 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). Risk-Adjusted Discount Rate
Risk-Adjusted Simply adjust the discount rate (k)
Simply adjust
to reflect higher risk.
to Riskier projects will use higher
Riskier
higher
risk-adjusted discount rates.
risk-adjusted Calculate NPV using the new riskadjusted discount rate. Risk-Adjusted Discount Rate
Risk-Adjusted
n NPV = Σ t=1 FCFt
t - IO
(1 + k*) Risk-Adjusted Discount Rates
Risk-Adjusted How do we determine the
How
appropriate risk-adjusted 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...

View
Full Document