Risk Analysis & Capital Budgeting

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Risk Analysis & Capital Budgeting

  1. 1. Risk analysis & Capital Budgeting
  2. 2. Risk adjusted discount rate approach <ul><li>Risk adjusted discount rate adjusts the discount rate rather than cash flows. </li></ul>
  3. 3. <ul><li>Year Proposal X Proposal Y </li></ul><ul><li>0 (500) (700) </li></ul><ul><li>1 145 100 </li></ul><ul><li>2 145 110 </li></ul><ul><li>3 145 130 </li></ul><ul><li>4 145 150 </li></ul><ul><li>5 145 160 </li></ul><ul><li>6 150 </li></ul><ul><li>7 120 </li></ul><ul><li>8 120 </li></ul><ul><li>9 110 </li></ul><ul><li>10 100 </li></ul><ul><li>The company employs the risk adjusted method of evaluating risky projects and selects the appropriate required rate of return as follows: </li></ul><ul><li>Pay back required rate of return </li></ul><ul><li>Less than 1 year 8 </li></ul><ul><li>1 to 5 years 10 </li></ul><ul><li>5 to 10 years 12 </li></ul><ul><li>Over 10 years 15 </li></ul><ul><li>Which proposal should be acceptable to the company? </li></ul>
  4. 4. Certainty equivalent approach <ul><li>The riskiness of the project is taken into consideration by adjusting the expected cash flows and not the discount rate. For this purpose, Certainty equivalent coefficient is calculated and multiplied with risky cash flows. it is equal to </li></ul><ul><li>Risk less cash flows </li></ul><ul><li>Risky cash flows </li></ul><ul><li>Then calculated certain cash flows are discounted as risk less discount rate. </li></ul>
  5. 5. <ul><li>A company employs CE approach in the evaluation of risky investments. The capital budgeting department of the company has developed the following information regarding a new project: </li></ul><ul><li>Year Expected CFAT CE quotient </li></ul><ul><li>0 200 1 </li></ul><ul><li>1 160 .8 </li></ul><ul><li>2 140 .7 </li></ul><ul><li>3 130 .6 </li></ul><ul><li>4 120 .4 </li></ul><ul><li>5 80 .3 </li></ul><ul><li>The firm’s cost of equity capital is 18 percent, its cost of debt is 9 percent and risk less rate of interest in the market on government securities is 6 percent. Should the project be accepted? </li></ul>

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