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Quiz 3
Midwest manufacturing
Company is considering two
mutually exclusive investments.
The projects’ expected cash
flow a...
Answer
a) Construct NPV (net
present value) if the cost of
capital is 10 percent.
Answer
b) Construct NPV (net present
value) if the cost of capital
is 17 percent.
Answer
c) If you were told that each
project’s cost is 10 percent,
which project should be
selected?
If the cost of capita...
Chapter 11: Capital Budget
Risk-Adjusted Discount Rates
A method for incorporating the project’s level of risk into the
ca...
Example 1
A toy manufacture is considering the introduction of a line of fishing
equipment with an expected life of five y...
Example 1

The project would have been accepted Project B with a net present value
$3,700
Example 2
Bennett Company wishes to apply the Risk-Adjusted Discount Rate (RADR)
approach to determine whether to implemen...
Example 2

The project would have been accepted Project B with a net present value
$9,802
Certainty Equivalent vs. Risk-Adjusted
Discount Rate Methods
Certainty Equivalent

Risk-Adjusted Discount Rate
Step 1 : Ad...
Certainty Equivalent Example

The risk-risk free rate of interest is 6
percent. What is the project’s net present
value?
Answer
Comparing Certainty Equivalent and
Risk Adjusted Discount Rate Methods
A firm with a required rate of return of 10 percent...
Comparing Certainty Equivalent and
Risk Adjusted Discount Rate Methods
Certainty Equivalent
Comparing Certainty Equivalent and
Risk Adjusted Discount Rate Methods
Risk-Adjusted Discount Rate Method
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Financial Management

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Financial Management

  1. 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. 2. Answer a) Construct NPV (net present value) if the cost of capital is 10 percent.
  3. 3. Answer b) Construct NPV (net present value) if the cost of capital is 17 percent.
  4. 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. 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. 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. 7. Example 1 The project would have been accepted Project B with a net present value $3,700
  8. 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. 9. Example 2 The project would have been accepted Project B with a net present value $9,802
  10. 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. 11. Certainty Equivalent Example The risk-risk free rate of interest is 6 percent. What is the project’s net present value?
  12. 12. Answer
  13. 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.
  14. 14. Comparing Certainty Equivalent and Risk Adjusted Discount Rate Methods Certainty Equivalent
  15. 15. Comparing Certainty Equivalent and Risk Adjusted Discount Rate Methods Risk-Adjusted Discount Rate Method

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