1.
Quiz 3
Midwest manufacturing
Company is considering two
mutually exclusive investments.
The projects’ expected cash
flow as follows.
a) Construct NPV (net
present value) if the cost
of capital is 10 percent.
b) Construct NPV (net
present value) if the cost
of capital is 17 percent.
c) If you were told that
each project’s cost is 10
percent, which project
should be selected? If
the cost of capital were
17 percent, what would
proper choice be?
2.
Answer
a) Construct NPV (net
present value) if the cost of
capital is 10 percent.
3.
Answer
b) Construct NPV (net present
value) if the cost of capital
is 17 percent.
4.
Answer
c) If you were told that each
project’s cost is 10 percent,
which project should be
selected?
If the cost of capital were 17
percent, what would proper
choice be?
10%
Project A : $7,918.75
Project B : - $ 405
We would select Project A because the
amount is more than 0
17%
Project A : $2,018.75
Project B : - $ 405
We would select Project A because the
amount is more than 0
5.
Chapter 11: Capital Budget
Risk-Adjusted Discount Rates
A method for incorporating the project’s level of risk into the
capital-budgeting process, in which the discount rate is adjusted
upward to compensate for higher than normal risk or downward
to adjust for lower than normal risk.
FCF
IO
K*
N
=
=
=
=
the annual expected free cash flow in time period t.
the initial cash outlay.
the risk-adjusted discount rate.
the project’s expected life.
6.
Example 1
A toy manufacture is considering the introduction of a line of fishing
equipment with an expected life of five years. In the past, this firm has been
quite conservative in its investment in new products, sticking primarily to
standard toys. In this context, the introduction of a line of fishing equipment
is considered an abnormally risky project. Management thinks that the
normal required rate of return for the firm of 10 percent is not sufficient.
Instead, the minimally acceptable rate of return on this project should be 15
percent. The initial outlay would be $110,000, and the expected free cash
flows from this project are as given below:
7.
Example 1
The project would have been accepted Project B with a net present value
$3,700
8.
Example 2
Bennett Company wishes to apply the Risk-Adjusted Discount Rate (RADR)
approach to determine whether to implement Project A or B.
rate of return on
Project A : 14%
Project B : 11%
9.
Example 2
The project would have been accepted Project B with a net present value
$9,802
10.
Certainty Equivalent vs. Risk-Adjusted
Discount Rate Methods
Certainty Equivalent
Risk-Adjusted Discount Rate
Step 1 : Adjust the discount rate
upward for risk, or down in the
case of less than normal risk.
Step 2 : Discount the expected free
cash flows back to the present
using the risk-adjusted
discount rate.
Step 3 : Apply the normal decision
criteria except in the case of
the internal rate of return,
where the risk-adjusted
discount rate replaces the
required rate of return as the
hurdle rate
11.
Certainty Equivalent Example
The risk-risk free rate of interest is 6
percent. What is the project’s net present
value?
13.
Comparing Certainty Equivalent and
Risk Adjusted Discount Rate Methods
A firm with a required rate of return of 10 percent is
considering introducing a new product. This product
has an initial outlay of $800,000, and expected life of
10 years, and free cash flows of $10 0,000 each year
during its life. Because of the increased risk associated
with this project, management is requiring a 15 percent
rate of return.
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