Capital Budgeting

2950 Words Feb 6th, 2013 12 Pages
Chapter 10
CAPITAL BUDGETING AND RISK

ANSWERS TO QUESTIONS: 1. The net present value model handles risk by discounting expected cash flows from a project by the firm's cost of capital. This discount rate is based upon the firm's average risk level. To the extent that a project has more than or less than average risk, the use of the firm's cost of capital will not make the appropriate risk adjustments. The basic model also does not explicitly consider the variability of a project's returns. 2. Risk, in the context of capital budgeting, is the possibility that actual returns from a project will differ from expected returns. It is often measured by the standard deviation of returns or the coefficient of variation of
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3. z = ($0 - $100,000) / $50,000 = - 2.0 P(z < - 2.0) = 0.0228, or 2.28% from Table V 4. a. Project A is riskier using the standard deviation criterion because it has a larger standard deviation than B. b. Coefficient of variation calculation: vA = $20,000/$50,000 = 0.4; vB = $7,000/$10,000 = 0.7 B is riskier using the coefficient of variation criterion. c. Because the projects are significantly different in size, the coefficient of variation criterion, a measure of relative risk, is more appropriate. 5. If reducing the variability of the firm's earnings is the desired objective, purchasing the supermarket chain is probably best. To reach this conclusion, it was necessary to assume that the correlation of returns between the supermarket chain and the steel firm as a whole is less than the correlation of returns between the new continuous caster and the steel firm as a whole. This seems to be a reasonable assumption. 6. a. ke = 8.0% + 1.5 (14% - 8%) = 17.0% b. ke = 8.0% + 2.0(14% - 8%) = 20.0% 7. a. ßu = 1.5/[1 + (1 - 0.4)(.333/.667)] = 1.15 ßl = 1.15[1 + (1 - 0.4)(10/90)] = 1.23 ke = 8% + 1.23(15% - 8%) = 16.6% b. ßu = 1.6/[1 + (1 - 0.35)(.20/.80)] = 1.38 ßl = 1.38[1 + (1 - 0.4)(10/90)] = 1.47 ke = 8% + 1.47(15% - 8%) =

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