Exam 12: Risk and Refinements in Capital Budgeting

A firm with unlimited funds must evaluate five projects. Projects 1 and 2 are independent and Projects 3, 4, and 5 are mutually exclusive. The projects are listed with their returns. A ranking of the projects on the basis of their returns from the best to the worst according to their acceptability to the firm would be ________.

A behavioral approach that evaluates the impact on a firm's return through simultaneous changes in a number variables of a project is called ________.

Table 12.6 Yong Importers, an Asian import company, is evaluating two mutually exclusive projects, A and B. The relevant cash flows for each project are given in the table below. The cost of capital for use in evaluating each of these equally risky projects is 10 percent. -The annualized NPV of Project B is ________. (See Table 12.6)

Table 12.5 Nico Manufacturing is considering investment in one of two mutually exclusive projects X and Y which are described below. Nico Manufacturing's overall cost of capital is 15 percent, the market return is 15 percent and the risk-free rate is 5 percent. Nico estimates that the beta for project X is 1.20 and the beta for project Y is 1.40. -Calculate the risk-adjusted discount rates for Project X and Project Y. (See Table 12.5)

The output of simulation provides an excellent basis for decision making since it allows the decision maker to view a continuum of risk-return trade-offs rather than a single-point estimate.

Table 12.2 A firm is considering investment in a capital project which is described below. The firm's cost of capital is 18 percent and the risk-free rate is 6 percent. The project has a risk index of 1.5. The firm uses the following equation to determine the risk adjusted discount rate, RADR, for each project: RADR = Rf + Risk Index (Cost of capital - Rf) -The net present value without adjusting the discount rate for risk is ________. (See Table 12.2)

The objective of ________ is to select the group of projects that provides the highest overall net present value and does not require more dollars than are budgeted.

Simulation is an approach that evaluates the impact on return of simultaneous changes in a number of variables.

The ________ approach is used to convert the net present value of unequal-lived projects into an equivalent annual amount (in net present value terms).

A firm is evaluating two mutually exclusive projects that have unequal lives. The firm must evaluate the projects using the annualized net present value approach and recommend which project they should select. The firm's cost of capital has been determined to be 18 percent, and the projects have the following initial investments and cash flows:

Table 12.4 Johnson Farm Implement is faced with two mutually exclusive projects, P and Q. The following are the data about the two projects. -Evaluate the projects using risk-adjusted discount rates. (See Table 12.4)

A(n) ________ allows management to avoid or minimize losses on projects that turn bad.

The objective of capital rationing is to select the group of projects that provides the highest overall net present value and does not require more dollars than are budgeted.

In case of unequal-lived, mutually exclusive projects, the use of net present value to select the better project results in an incorrect decision.

Table 12.3 Tangshan Mining Company is considering investment in one of two mutually exclusive projects M and N which are described below. Tangshan Mining's overall cost of capital is 15 percent, the market return is 15 percent and the risk-free rate is 5 percent. Tangshan estimates that the beta for project M is 1.20 and the beta for project N is 1.40. -Which project would be preferable if both projects were of average risk as the overall firm and Tangshan Mining has a beta of 1.0? (See Table 12.3)

Scenario analysis is a behavioral approach that evaluates the impact on a firm's return through simultaneous changes in a number of variables.

RADRs are popular because they are consistent with the general disposition of financial decision makers toward rates of return.

Scenario analysis is a statistics-based behavioral approach that applies predetermined probability distributions and random numbers to estimate risky outcomes.

When unequal-lived projects are independent, the length of the project lives is not critical.

Table 12.6 Yong Importers, an Asian import company, is evaluating two mutually exclusive projects, A and B. The relevant cash flows for each project are given in the table below. The cost of capital for use in evaluating each of these equally risky projects is 10 percent. -Which project should be chosen on the basis of the normal NPV approach? (See Table 12.6)