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Risk and
Refinements
in Capital
Budgeting
Learning Goals
1. Understand the importance of recognizing risk
in the analysis of capital budgeting projects.
2. Discuss breakeven cash inflow, scenario
analysis, and simulation as behavioral
approaches for dealing with risk.
3. Discuss the unique risks that multinational
companies face.
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Introduction to Risk
in Capital Budgeting
Thus far in our exploration of capital budgeting, all
projects were assumed to be equally risky.
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Introduction to Risk
in Capital Budgeting (cont.)
Table 10.1 Cash Flows and NPVs for Bennett Companys
Projects
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Behavioral Approaches
for Dealing with Risk
In the context of the capital budgeting projects
discussed in this chapter, risk results almost entirely
from the uncertainty about future cash inflows,
because the initial cash outflow is generally known.
These risks result from a variety of factors including
uncertainty about future revenues, expenditures and
taxes.
Therefore, to asses the risk of a potential project, the
analyst needs to evaluate the riskiness of the cash
inflows.
Copyright 2009 Pearson Prentice Hall. All rights reserved.
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Behavioral Approaches
for Dealing with Risk
Figure 10.1
NPV
Simulation
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International
Risk Considerations (cont.)
Political risk is much harder to protect against once a
project is implemented.
A foreign government can block repatriation of profits
and even seize the firms assets.
Accounting for these risks can be accomplished by
adjusting the rate used to discount cash flowsor
betterby adjusting the projects cash flows.
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International
Risk Considerations (cont.)
Since a great deal of cross-border trade among
MNCs takes place between subsidiaries, it is
also important to determine the net incremental
impact of a projects cash flows overall.
As a result, it is important to approach
international capital projects from a strategic
viewpoint rather than from a strictly financial
perspective.
Copyright 2009 Pearson Prentice Hall. All rights reserved.
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Risk-Adjustment Techniques:
Portfolio Effects
As noted earlier, individual investors must hold diversified
portfolios because they are not rewarded for assuming
diversifiable risk.
Because business firms can be viewed as portfolios of assets, it
would seem that it is also important that they too hold diversified
portfolios.
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Risk-Adjustment Techniques:
Portfolio Effects (cont.)
It turns out that firms are not rewarded for
diversification because investors can do so
themselves.
An investor can diversify more readily, easily,
and costlessly simply by holding portfolios of
stocks.
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Capital Rationing
Firms often operate under conditions of capital rationing
they have more acceptable independent projects than they can
fund.
In theory, capital rationing should not existfirms should
accept all projects that have positive NPVs.
However, research has found that management internally
imposes capital expenditure constraints to avoid what it deems to
be excessive levels of new financing, particularly debt.
Thus, the objective of capital rationing is to select the group of
projects within the firms budget that provides the highest overall
NPV or IRR.
Copyright 2009 Pearson Prentice Hall. All rights reserved.
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Capital Rationing
Tate Company, a fast growing plastics company with a
cost of capital of 10%, is confronted with six projects
competing for its fixed budget of $250,000. The initial
investment and IRR for each project are shown below:
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