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Chapter12

RiskandRefinementsinCapitalBudgeting
Instructors Resources
Overview
Chapters10and11developedthemajordecisionmakingaspectsofcapitalbudgeting.Cashflowsand
budgetingmodelshavebeenintegratedanddiscussedinprovidingtheprinciplesofcapitalbudgeting.
However,therearemorecomplexissuesbeyondthosepresented.Chapter12expandscapitalbudgeting
toconsiderriskwithsuchmethodsasscenarioanalysisandsimulation.Capitalbudgetingtechniques
usedtoevaluateinternationalprojects,aswellasthespecialrisksmultinationalcompaniesface,arealso
presented.Additionally,twobasicriskadjustmenttechniquesareexamined:certaintyequivalentsand
riskadjusteddiscountrates.Thechapterpresentsstudentswithseveralexamplesoftheapplicationofrisk
basedrefinementswhencapitalbudgetingintheirprofessionalandpersonallife.

Suggested Answer to Opener in Review Question


ThechapteropenerandtheFocusonEthicsboxinthischapterdescribedsomeoftheconsequences
oftheaccidentatBPsDeepwaterHorizonoilrig.ItisplausiblethatengineersandanalystsatBP
couldhaveimaginedaworstcasescenarioinwhichamajorspilloccurredatoneofthefirms
offshorerigs.HowmightathoroughscenarioanalysishaveinfluencedBPsoffshoredrilling
activities?
AnincreaseinthecostofcapitalmeansthatthemarketisdiscountingBPscashflowsatahigherrate.
ThatincludescashflowsfromBPsexistinginvestmentsaswellasinvestmentsthatthemarkethad
anticipatedthatBPwouldmakeinthefuture(andhencehadalreadybeenincorporated,atleastpartially,
intoBPsstockprice).Wehaveseenthatanincreaseinthediscountrateleadstoadeclineinthepresent
valueofacashflowstream,soitislogicalthatajumpinBPscostsofcapitalwouldbeassociatedwitha
majordropinthefirmsoverallvalue.
IfBPanalystshadimaginedthecostsofamajoroilspillasaworstcasescenario,itseemslikelythatBP
wouldhavetakenwhateverstepswerenecessarytopreventsuchanaccident.Thecashinflowsgenerated
byanoffshoreplatformareswampedbythecostsofamajorspill.Notallaccidentsarepreventable,of
course,butthefactthatBPengineerscouldnotquicklystoptheflowofoilintotheGulfofMexico
suggeststhatanaccidentofthetypethatoccurredontheoilrighadnotbeenplannedforinadvance.

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Chapter12RiskandRefinementsinCapitalBudgeting250

Answers to Review Questions


1. There is usually a significant degree of uncertainty associated with capital budgeting projects. There is the usual
business risk along with the fact that future cash flows are an estimate and do not represent exact values. The
uncertainly of each project cash flow stream will be different and thus each project has its own unique risk. This
uncertainty exists for both independent and mutually exclusive projects. The risk associated with any single
project has the capability to change the entire risk of the firm. The firms assets are like a portfolio of assets. If
an accepted capital budgeting project has a risk different from the average risk of the assets in the firm, it will
cause a shift in the overall risk of the firm.

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Chapter12RiskandRefinementsinCapitalBudgeting251

2. Risk, in terms of cash inflows from a project, is the variability of expected cash flows, hence the expected
returns, of the given project. The breakeven cash inflow the level of cash inflow necessary in order for the
project to be acceptable may be compared with the probability of that inflow occurring. When comparing two
projects with the same breakeven cash inflows, the project with the higher probability of occurrence is less
risky.
3. a.

Scenario analysis uses a number of possible inputs (cash inflows) to assess their impact on
the firms net present value (NPV) return. Scenario analysis can be used to evaluate the impact on return of
simultaneous changes in a number of variables, such as cash inflows, cash outflows, and the cost of capital,
resulting from differing assumptions relative to economic and competitive conditions. In capital budgeting,
the NPVs are frequently estimated for the pessimistic, most likely, and optimistic cash flow estimates. By
subtracting the pessimistic outcome NPV from
the optimistic outcome NPV, a range of NPVs can be determined.

b. Simulationisastatisticallybasedapproachusingrandomnumberstosimulatevariouscashflows
associatedwiththeproject,calculatingtheNPVorinternalrateofreturn(IRR)onthebasisof
thesecashflows,andthendevelopingaprobabilitydistributionofeachprojectsrateofreturns
basedonNPVorIRRcriterion.
4. a.

Multinational companies (MNCs) must consider the effect of exchange rate risk, the risk that the exchange
rate between the dollar and the currency in which the projects cash flows are denominated will reduce the
projects future cash flows. If the value of the dollar depreciates relative to that currency, the dollar value of
the projects cash flows will increase as a result. Firms can use hedging to protect themselves against this
risk in the short term; for the long term, financing the project using local currency can minimize this risk.

b. Politicalrisk,theriskthataforeigngovernmentsactionswilladverselyaffecttheproject,makes
internationalprojectsparticularlyrisky,becauseitcannotbepredictedinadvance.Totakethis
riskintoaccount,managersshouldeitheradjustexpectedcashflowsoruseriskadjusteddiscount
rateswhenperformingthecapitalbudgetinganalysis.Adjustmentofcashflowsisthepreferred
method.
c.

Taxlawsdifferfromcountrytocountry.Becauseonlyaftertaxcashflowsarerelevantforcapital
budgetingdecisions,managersmustaccountforalltaxespaidtoforeigngovernmentsandconsider
theeffectofanyforeigntaxpaymentsonthefirmsU.S.taxliability.

d. Transferpricingreferstothepriceschargedbyacorporationssubsidiariesforgoodsandservices
tradedbetweenthem;thepricesarenotsetbytheopenmarket.Intermsofcapitalbudgeting
decisions,managersshouldbesurethattransferpricesaccuratelyreflectactualcostsand
incrementalcashflows.
e.

MNCscannotevaluateinternationalcapitalprojectsfromonlyafinancialperspective.The
strategicviewpointoftenisthedeterminingfactorindecidingwhetherornottoundertakea
project.Infact,aprojectthatislessacceptablethananotheronapurelyfinancialbasismay
bechosenforstrategicreasons.SomereasonsforMNCforeigninvestmentincludecontinued
marketaccess,theabilitytocompetewithlocalcompanies,politicaland/orsocialreasons
(forexample,gainingfavorabletaxtreatmentinexchangeforcreatingnewjobsinacountry),
andachievementofaparticularcorporateobjectivesuchasobtainingareliablesourceofraw
materials.

5. Risk-adjusted discount rates (RADRs) reflect the return that must be earned on a given project in order to
adequately compensate the firms owners. The relationship between RADRs and the capital asset pricing model
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(CAPM) is a purely theoretical concept. The expression used to value the expected rate of return of a security ki
(ki RF [b (km RF)]) is rewritten substituting an asset for a security. Because real corporate assets are not
traded in efficient markets and estimation of a market return, km, for a portfolio of such assets would be
difficult, the CAPM is not used for real assets.
6. A firm whose stock is actively traded in security markets generally does not increase in value through
diversification. Investors themselves can more efficiently diversify their portfolio by holding a variety of stocks.
Since a firm is not rewarded for diversification, the risk of a capital budgeting project should be considered
independently rather than in terms of their impact on the total portfolio of assets. In practice, management
usually follows this approach and evaluates projects based on their total risk.
7. RADRs are most often used in practice for two reasons: (1) financial decision makers prefer using rate of
return-based criteria, and (2) they are easy to estimate and apply. In practice, risk is subjectively categorized
into classes, each having a RADR assigned to it. Each project is then subjectively placed in the appropriate risk
class.
8. A comparison of NPVs of unequal-lived mutually exclusive projects is inappropriate because it may lead to an
incorrect choice of projects. The annualized net present value (ANPV) converts the NPV
of unequal-lived projects into an annual amount that can be used to select the best project.
9. Real options are opportunities embedded in real assets that are part of the capital budgeting process. Managers
have the option of implementing some of these opportunities to alter the cash flow and risk of a given project.
Examples of real options include:
Abandonmentthe option to abandon or terminate a project prior to the end of its planned life.
Flexibilitythe ability to adopt a project that permits flexibility in the firms production process, such as being
able to reconfigure a machine to accept various types of inputs.
Growththe option to develop follow-on projects, expand markets, expand or retool plants, and so on, that
would not be possible without implementation of the project that is being evaluated.
Timingthe ability to determine the exact timing of when various action of the project will be undertaken.
10.

Strategic NPV incorporates the value of the real options associated with the project while traditional NPV
includes only the identifiable relevant cash flows. Using strategic NPV could alter the final accept/reject
decision. It is likely to lead to more accept decisions since the value of the options is added to the traditional
NPV, as shown in the following equation.

NPVstrategicNPVtraditionalValueofrealoptions
11.

Capital rationing is a situation where a firm has only a limited amount of funds available for capital
investments. In most cases, implementation of the acceptable projects would require more capital than is
available. Capital rationing is common for a firm, since unfortunately most firms do not have sufficient capital
available to invest in all acceptable projects. In theory, capital rationing should not exist because firms should
accept all projects with positive NPVs or IRRs greater than the cost of capital. However, most firms operate
with finite capital expenditure budgets and must select the best from all acceptable projects, taking into account
the amount of new financing required to fund these projects.

12. The IRR approach and the NPV approach to capital rationing both involve ranking projects on the basis of
IRRs. Using the IRR approach, a cut-off rate and a budget constraint are imposed. The NPV first ranks projects
by IRR and then takes into account the present value of the benefits from each project in order to determine the
combination with the highest overall net present value. The benefit of the NPV approach is that it guarantees a
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Chapter12RiskandRefinementsinCapitalBudgeting253

maximum dollar return to the firm, whereas the IRR approach does not.

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Suggested Answer to Focus on Practice Box: The Monte Carlo


Method: The Forecast Is for Less Uncertainty
AMonteCarlosimulationprogramrequirestheusertofirstbuildanExcelspreadsheetmodelthat
capturestheinputvariablesfortheproposedproject.Whatissuesandwhatbenefitscantheuser
derivefromthisprocess?
AgoodMonteCarlosimulationrequiresreasonablyaccurateestimatesofdata,includingprojectedsales
figures,productioncosts,associatedoverhead,marketingcosts,andothercostsrelatedtotheproject.
Gatheringthistypeofdatafornumerousprojectscanbeexpensiveintermsofemployeehours.However,
anysoundevaluationofaprojectwilleventuallyrequiresuchinformationgatheringbeforeadecisioncan
bemade.ThebenefitoftheMonteCarloprogramisthatitcanquicklyprovidearangeofprobableoutcomes
asthepotentialinputsarevaried.Forexample,ifthemarketingvariableisincreased,theeffectonpossible
salesoutcomecanbequicklydemonstrated.
Butevenbeyondthequickanalysisoftheeffectofchangingaprojectvariableisthattheneedforaccurate
andreasonableestimateswillforceprojectdeveloperstospendsometimeandefforttodeveloptheproper
dataforinputintotheMonteCarloprogram.Workingdiligentlytofindreliablecostestimatesandmarketing
estimatescanonlyenhancetheviabilityofaproposedprojectifitmeetsthecompanysselectioncriteria.

Suggested Answer to Focus on Ethics Box:


Ethics and the Cost of Capital
Istheultimategoalofthefirm,tomaximizethewealthoftheownersforwhomthefirmisbeing
operated,ethical?
Itisnotthegoalthatmakesmaximizationofshareholderwealthethicalorunethical,itisactionsofthe
financialmanagerinpursuitofthisgoalthatdictatesthelevelofethics.
Whymightethicalcompaniesbenefitfromalowercostofcapitalthanlessethicalcompanies?
Ifethicalbehaviorreducestheriskofinvestinginacompany(e.g.,reducesthevolatilityofthefirmscash
flows),ethicalcompaniesshouldbenefitmorefromalowercostofcapitalthanlessethicalcompanies.

Answers to Warm-Up Exercises


E12-1.

Sensitivity analysis

Answer: Usingthe12%costofcapitaltodiscountallofthecashflowsforeachscenariotoyieldthe
followingNPVs,resultinginaNPVrangeof$19,109.78:
Pessimistic

MostLikely

Optimistic

$3,283.48

$6,516.99

$15,826.30

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E12-2.

Using IRR as selection criteria

Answer: Theminimumamountofannualcashinflowneededtoearn8%is$11,270.54
N5,I8%,PV$45,000
SolveforPMT$11,270.54
TheIRRoftheprojectis12.05%.
N5,PV$45,000,PMT$12,500
SolveforI$12.05%
TheprojectisacceptablesinceitsIRRexceedsthefirms8%costofcapital.Sincetherequired
cashflowismuchlessthantheanticipatedcashflow,onewouldexpecttheIRRtoexceedthe
requiredrateofreturn.
E12-3.

Risk-adjusted discount rates

Answer: ProjectSourdoughRADR7.0%
N7,I7%,PMT$5,500
SolveforPV$29,641.09
NPVPVnInitialinvestment
NPV$29,641.09$12,500
NPV$17,141.09
ProjectGreekSaladRADR8.0%
N7,I8%,PMT$4,000
SolveforPV$20,825.48
NPVPVnInitialinvestment
NPV$20,825.48$7,500
NPV$13,325.48
YeastimeshouldselectProjectSourdough.
E12-4.

ANPV

Answer: YoumayuseafinancialcalculatortodeterminetheIRRofeachproject.Choosetheproject
withthehigherIRR.
ProjectM
Step1:

FindtheNPVoftheproject

NPVMKeystrokes
CF0$35,000,CF1$12,000,CF2$25,000,CF3$30,000
SetI8%
SolveforNPV$21,359.55
Step2:

FindtheANPV
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N3,I8,PV$21,359.55
SolveforPMT$8,288.22

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Chapter12RiskandRefinementsinCapitalBudgeting257

ProjectN
Step1:

FindtheNPVoftheproject

NPVMKeystrokes
CF0$55,000,CF1$18,000,CF2$15,000,CF3$25,000
CF4$10,000,CF5$8,000,CF6$5,000,CF7$5,000
SetI8%
SolveforNPV$13,235.82
Step2:

FindtheANPV

N7,I8,PV$13,235.82
SolveforPMT$2,542.24
BasedonANPV,youshouldadviseOutcast,Inc.tochooseProjectM.
E12-5.

NPV profiles

Answer: Theinvestmentopportunityschedule(IOS)inthisproblemdoesnotallowustodeterminethe
maximumNPVallowedbythebudgetconstraint.InordertodeterminewhethertheIOS
maximizestheNPVforLongchampsElectric,wewillneedtoknowtheNPVforeachofthe
sixprojects.However,itdoesappearlikelythatLongchampsElectricwillmaximizefirmvalue
byselectingProject4(IRR11%),Project2(IRR10%),andProject5(IRR9%).Thetotal
investmentinthesethreeprojectswillbe$135,000,leaving$15,000excesscashforfuture
investmentopportunities.

Solutions to Problems
P121. Recognizingrisk
LG1;Basic
a.andb.
Project

Risk

Reason

Low

Thecashflowsfromtheprojectcanbeeasilydeterminedsince
thisexpenditureconsistsstrictlyofoutflows.Theamountisalso
relativelysmall.

Medium

ThecompetitivenatureoftheindustrymakesitsothatCaradine
willneedtomakethisexpendituretoremaincompetitive.Therisk
isonlymoderatesincethefirmalreadyhasclientsinplacetouse
thenewtechnology.

Medium

Sincethefirmisonlypreparingaproposal,theircommitmentat
thistimeislow.However,the$450,000isalargesumofmoney
forthecompanyanditwillimmediatelybecomeasunkcost.

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High

AlthoughthispurchaseisintheindustryinwhichCaradine
normallyoperates,theyareencounteringalargeamountofrisk.
Thelargeexpenditure,thecompetitivenessoftheindustry,andthe
politicalandexchangeriskofoperatinginaforeigncountryaddto
theuncertainty.

Note:Otheranswersarepossibledependingontheassumptionsastudentmaymake.Thereistoo
littleinformationgivenaboutthefirmandindustrytoestablishadefinitiveriskanalysis.

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P122. Breakevencashflows
LG2;Intermediate
a.

N12,I14%,PV$35,000
SolveforPMT$6,183.43

b. N12,I10%,PV$35,000
SolveforPMT$5,136.72
Therequiredcashflowperyearwoulddecreaseby$1,047.27.
P123. Breakevencashinflowsandrisk
LG2;Intermediate
a.

ProjectX

ProjectY

N5,I15%,PMT$10,000

N5,I15%,PMT$15,000

SolveforPV33,521.55

SolveforPV$50,282.33

NPV PVinitialinvestment

NPV PVinitialinvestment

NPV $33,521.55$30,000

NPV $50,282.33$40,000

NPV $3,521.55

NPV $10,282.33

b. ProjectX

c.

ProjectY

N5,I15%,PV$30,000

N5,I15%,PV$40,000

SolveforPMT$8,949.47

SolveforPMT$11,932.62

ProjectX

ProjectY

Probability60%

Probability25%

d. ProjectYismoreriskyandhasahigherpotentialNPV.ProjectXhaslessriskandlessreturn
whileProjectYhasmoreriskandmorereturn,thustheriskreturntradeoff.
e.

ChooseProjectXtominimizelosses;toachievehigherNPV,chooseProjectY.

P124. Basicscenarioanalysis
LG2;Intermediate
a.

RangeA$1,800$200$1,600 RangeB$1,100$900$200

b.
NPVs
Outcome

ProjectA

ProjectB

Pessimistic

$6,297.29

$337.79

Mostlikely

513.56

513.56

7,324.41

1,364.92

Optimistic

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Range
c.

$13,621.70

$1,702.71

AlthoughthemostlikelyoutcomeisidenticalforProjectAandB,theNPVrangevaries
considerably.

d. Projectselectionwoulddependupontheriskdispositionofthemanagement.(Aismorerisky
thanBbutalsohasthepossibilityofagreaterreturn.)

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P125. Scenarioanalysis
LG2;Intermediate
a.

RangeP$1,000$500$500
RangeQ$1,200$400$800

b.
NPVs

c.

Outcome

ProjectP

ProjectQ

Pessimistic

$72.28

$542.17

Mostlikely

1,608.43

1,608.43

Optimistic

3,144.57

4,373.48

RangeP$3,144.57$72.28$3,072.29
RangeQ$4,373.48($542.17)$4,915.65
Eachcomputerhasthesamemostlikelyresult.ComputerQhasbothagreaterpotentialloss
andagreaterpotentialreturn.Therefore,thedecisionwilldependontheriskdispositionof
management.

P126. PersonalFinance:Impactofinflationoninvestments
LG2;Easy
a.c.

Investment
Cash Flows
Year

Current
NPV (a)

Higher
Inflation
NPV (b)

Lower
Inflation
NPV (c)

(7,500)

(7,500)

(7,500)

(7,500)

2,000

1,878

1,860

1,896

2,000

1,763

1,731

1,797

2,000

1,656

1,610

1,703

1,500

1,166

1,123

1,211

1,500

1,095

1,045

1,148

$ 58

$ (131)

$ 254

Total NPV

d. AstheinflationraterisestheNPVofagivensetofcashflowsdeclines.
P127. Simulation
LG2;Intermediate
a.

OgdenCorporationcoulduseacomputersimulationtogeneratetherespectiveprofitability
distributionsthroughthegenerationofrandomnumbers.Bytyingvariouscashflowassumptions
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togetherintoamathematicalmodelandrepeatingtheprocessnumeroustimes,aprobability
distributionofprojectreturnscanbedeveloped.Theprocessofgeneratingrandomnumbers
andusingtheprobabilitydistributionsforcashinflowsandoutflowsallowsvaluesforeach
ofthevariablestobedetermined.Theuseofthecomputeralsoallowsformoresophisticated
simulationusingcomponentsofcashinflowsandoutflows.Substitutionofthesevaluesinto
themathematicalmodelyieldstheNPV.Thekeyliesinformulatingamathematicalmodel
thattrulyreflectsexistingrelationships.
b. Theadvantagestocomputersimulationsincludethedecisionmakersabilitytoview
acontinuumofriskreturntradeoffsinsteadofasinglepointestimate.Thecomputer
simulation,however,isnotfeasibleforriskanalysis.
P128. RiskadjusteddiscountratesBasic
LG4;Intermediate
a.

ProjectE
N4,I15%,PMT$6,000
SolveforPV$17,129.87
NPV$17,129.87$15,000
NPV$2,129.87
ProjectF
CF0$11,000,CF1$6,000,CF2$4,000,CF3$5,000,CF4$2,000
SetI15%
SolveforNPV$1,673.05
ProjectG
CF0$19,000,CF1$4,000,CF2$6,000,CF3$8,000,C44$12,000
SetI15%
SolveforNPV$1,136.29
ProjectE,withthehighestNPV,ispreferred.

b. RADRE0.10(1.80(0.150.10))0.19
RADRF0.10(1.00(0.150.10))0.15
RADRG0.10(0.60(0.150.10))0.13
c.

ProjectE
N4,I19%,PMT$6,000
SolveforPV$15,831.51
NPV$15,831.51$15,000
NPV$831.51
ProjectF

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Sameasinparta,$1,673.05
ProjectG
CF0$19,000,CF1$4,000,CF2$6,000,CF3$8,000,CF4$12,000
SetI13%
SolveforNPV$2,142.93
Rank

Project

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d. Afteradjustingthediscountrate,eventhoughallprojectsarestillacceptable,theranking
changes.ProjectGhasthehighestNPVandshouldbechosen.
P129. RiskadjusteddiscountratesTabular
LG4;Intermediate
a.

ProjectA
N5,I8%,PMT$7,000
SolveforPV$27,948.97
NPV$27,948.97$20,000
NPV$7,948.97
ProjectB
N5,I14%,PMT$10,000
SolveforPV$34,330.81
NPV$34,330.81$30,000
NPV$4,330.81
ProjectA,withthehigherNPV,shouldbechosen.

b. ProjectAispreferabletoProjectB,sincetheNPVofAisgreaterthantheNPVofB.
P1210. PersonalFinance:Mutuallyexclusiveinvestmentandrisk
LG4;Intermediate
a.

N6,I8.5%,PMT$3,000
SolveforPV13,660.76
NPV$13,660.76$10,000
NPV$3,660.76

b. N6,I10.5%,PMT$3,800
SolveforPV$16,310.28
NPV$16,31.28$12,000
NPV$4,310.28
c.

UsingNPVasherguide,Larashouldselectthesecondinvestment.IthasahigherNPV.

d. Thesecondinvestmentisriskier.Thehigherrequiredreturnimpliesahigherriskfactor.
P1211. RiskadjustedratesofreturnusingCAPM
LG4;Challenge
a.

rX7%1.2(12%7%)7%6%13%
rY7%1.4(12%7%)7%7%14%
NPVcalculationforX:
N4,I13%,PMT$30,000
SolveforPV89,234.14
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Chapter12RiskandRefinementsinCapitalBudgeting265

NPV$89,234.14$70,000
NPV$19,234.14
NPVcalculationforY:
CF0$78,000,CF1$22,000,CF2$32,000,CF3$38,000,CF4$46,000
SetI14%
SolveforNPV$18,805.82
b. TheRADRapproachprefersProjectYoverProjectX.TheRADRapproachcombinesthe
riskadjustmentandthetimeadjustmentinasinglevalue.TheRADRapproachismostoften
usedinbusiness.
P1212. RiskclassesandRADR
LG4;Basic
a.

ProjectX
CF0$180,000,CF1$80,000,CF2$70,000,CF3$60,000,
CF4$60,000,CF5$60,000
SetI22%
SolveforNPV$14.930.45
ProjectY
CF0$235,000,CF1$50,000,CF2$60,000,
CF3$70,000,CF4$80,000,CF5$90,000
SetI13%
SolveforNPV$2,663.99
ProjectZ
CF0$310,000,CF1$90,000,CF2$90,000,CF3$90,000,
CF4$90,000,CF5$90,000
[or,CF0$310,000,CF1$90,000,F15]
SetI15%
SolveforNPV$8,306.04

b. ProjectsXandYareacceptablewithpositiveNPVs,whileProjectZwithanegativeNPVis
not.ProjectX,withthehighestNPV,shouldbeundertaken.
P1213. UnequallivesANPVapproach
LG5;Intermediate
a.

MachineA
CF0$92,000,CF1$12,000,CF2$12,000,CF3$12,000,

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CF4$12,000,CF5$12,000,CF6$12,000
[or,CF0$92,000,CF1$12,000,F16]
SetI12%
SolveforNPV$42,663.11
MachineB
CF0$65,000,CF1$10,000,CF2$20,000,CF3$30,000,CF4$40,000
SetI12%
SolveforNPV$6,646.58
MachineC
CF0$100,500,CF1$30,000,CF2$30,000,
CF3$30,000,CF4$30,000,CF5$30,000
[or,CF0$105,000,CF1$30,000,F15]
SetI12%
SolveforNPV$7,643.29
Rank

Machine

(NotethatMachineAisnotacceptableandcouldberejectedwithoutanyadditionalanalysis.)
b. MachineA
N6,I12%,PV$42,663.11
SolveforANPV(PMT)$10,376.77
MachineB
N4,I12%,PV$6,646.58
SolveforANPV(PMT)$2,188.28
MachineC
N5,I12%,PV$7,643.29
SolveforANPV(PMT)$2,120.32
Rank

Machine

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Chapter12RiskandRefinementsinCapitalBudgeting267

c.

MachineBshouldbeacquiredsinceitoffersthehighestANPV.Notconsideringthe
differenceinprojectlivesresultedinadifferentrankingbasedinpartonMachineCs
NPVcalculations.

P1214. UnequallivesANPVapproach
LG5;Intermediate
a.

ProjectX
CF0$78,000,CF1$17,000,CF2$25,000,CF3$33,000,CF4$41,000
SetI14%
SolveforNPV$2,698.32
ProjectY
CF0$52,000,CF1$28,000,CF2$38,000
SetI14%
SolveforNPV$1,801.17
ProjectZ
CF0$66,000,CF1$15,000,CF2$15,000,CF3$15,000,CF4$15,000,
CF5$15,000,CF6$15,000,CF7$15,000,CF8$15,000
[or,CF0$66,000,CF1$15,000,F18]
SetI14%
SolveforNPV$3,582.96
Rank

Project

b. ProjectX
N4,I14%,PV$
SolveforANPV(PMT)$9,260.76
ProjectY
N2,I14%,PV$1801.17
SolveforANPV(PMT)$1,093.83
ProjectZ
N5,I14%,PV$3582.96
SolveforANPV(PMT)$1,043.65
Rank

Project

X
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c.

ProjectYshouldbeacquiredsinceitoffersthehighestANPV.Notconsideringthedifference
inprojectlivesresultedinadifferentrankingbasedprimarilyontheunequallivesofthe
projects.

P1215. UnequallivesANPVapproach
LG5;Intermediate
a.

Sell
CF0$200,000,CF1$200,000,CF2$250,000
SetI12%
SolveforNPV$177,869.90
License
CF0$200,000,CF1$250,000,CF2$100,000
CF3$80,000,CF4$60,000,CF5$40,000
SetI12%
SolveforNPV$220,704.25
Manufacture
CF0$450,000,CF1$200,000,CF2$250,000,CF3$200,000,
CF4$200,000,CF5$200,000,CF6$200,000
[or,CF0$450,000,CF1$200,000,F11,
CF2$250,000,F21,CF3$200,000,F34]
SetI12%
SolveforNPV$412,141.16
Rank

Alternativ
e

Manufactur
e

License

Sell

b. Sell
N2,I12%,PV$

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Chapter12RiskandRefinementsinCapitalBudgeting269

SolveforANPV(PMT)$105,245.28
License
N5,I12%,PV$220,704.25
SolveforANPV(PMT)$61,225.51
Manufacture
N6,I12%,PV$412,141.16
SolveforANPV(PMT)$100,243.33

c.

Rank

Alternati
ve

Sell

Manufact
ure

License

ComparingtheNPVsofprojectswithunequallivesgivesanadvantagetothoseprojectsthat
generatecashflowsoverthelongerperiod.ANPVadjustsforthedifferencesinthelengthof
theprojectsandallowsselectionoftheoptimalproject.Thistechniqueimplicitlyassumes
thatallprojectscanbeselectedagainattheirconclusionaninfinitenumberoftimes.

P1216. NPVandANPVdecisions
LG5;Challenge
a. b.

Unequal-Life Decisions
Annualized Net Present Value (ANPV)

Cost
Annual Benefits
Life

Sony

$(2,350)

$(2,700)

$900
3 years

Terminal value
Required rate of return

a.

Samsung

$400
9.0%

$1,000
4 years
$350
9.0%

CF0$2,350,CF1$900,CF2$900,CF3$900+$400$1,300
SetI9%
SolveforNPV$237.04

b. N3,I9%,PV$237.04
SolveforANPV(PMT)$93.64
c.

CF0$2,700,CF1$1,000,CF2$1,000,CF3$1,000,CF4$1,000+$350$1,350
SetI9%

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SolveforNPV$787.67
d. N4,I9%,PV$787.67
SolveforANPV(PMT)$243.13
e.

RichardandLindashouldselecttheSonysetbecauseitsANPVof$243.13isgreaterthanthe
$93.64ANPVofSamsung.

P1217. RealoptionsandthestrategicNPV
LG6;Intermediate
a.

Valueofrealoptionsvalueofabandonmentvalueofexpansionvalueofdelay
Valueofrealoptions(0.25$1,200)(0.30$3,000)(0.10$10,000)
Valueofrealoptions$300$900$1,000$2,200
NPVstrategicNPVtraditionalValueofrealoptions1,7002,200$500
b. DuetotheaddedvaluefromtheoptionsReneshouldrecommendacceptanceofthecapital
expendituresfortheequipment.
c. Ingeneralthisproblemillustratesthatbyrecognizingthevalueofrealoptionsaprojectthat
wouldotherwisebeunacceptable(NPVtraditional0)couldbeacceptable(NPVstrategic0).Itis
thusimportantthatmanagementidentifyandincorporaterealoptionsintotheNPVprocess.
P1218. CapitalrationingIRRandNPVapproaches
LG6;Intermediate
a.

RankbyIRR
Project

IRR

InitialInvestment

TotalInvestment

$2,500,000

$2,500,000

23%

22

800,000

3,300,000

20

1,200,000

4,500,000

19

18

17

16

ProjectsF,E,andGrequireatotalinvestmentof$4,500,000andprovideatotalpresentvalue
of$5,200,000,andthereforeanNPVof$700,000.
b. RankbyNPV(NPVPVInitialinvestment)
Project
F
A

NPV
$500,000
400,000

Initial Investment
$2,500,000
5,000,000

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Chapter12RiskandRefinementsinCapitalBudgeting271

C
B
D
G
E

300,000
300,000
100,000
100,000
100,000

2,000,000
800,000
1,500,000
1,200,000
800,000

ProjectAcanbeeliminatedbecausewhileithasanacceptableNPV,itsinitialinvestment
exceedsthecapitalbudget.ProjectsFandCrequireatotalinitialinvestmentof$4,500,000
andprovideatotalpresentvalueof$5,300,000andanetpresentvalueof$800,000.However,
thebestoptionistochooseProjectsB,F,andG,whichalsousetheentirecapitalbudgetand
provideanNPVof$900,000.
c.

Theinternalrateofreturnapproachusestheentire$4,500,000capitalbudgetbutprovides
$200,000lesspresentvalue($5,400,000$5,200,000)thantheNPVapproach.Sincethe
NPVapproachmaximizesshareholderwealth,itisthesuperiormethod.

d. ThefirmshouldimplementProjectsB,F,andG,asexplainedinpartc.
P1219. CapitalRationingNPVApproach
LG6;Intermediate
Project

PV

A
B
C
D
E
F
G

$384,000
210,000
125,000
990,000
570,000
150,000
960,000

Initial Investment

Total Investment

$100,000

$100,000

$100,000
$800,000

$200,000
$1,000,000

b. TheoptimalgroupofprojectsisProjectsC,F,andG,resultinginatotalnetpresentvalueof
$235,000.ProjectGwouldbeacceptedfirstbecauseithasthehighestNPV.Itsselection
leavesenoughofthecapitalbudgettoalsoacceptProjectCandProjectF.
P1220. Ethicsproblem
LG4;Challenge
Studentanswerswillvary.Somestudentsmightarguethatcompaniesshouldbeheldaccountable
foranyandallpollutionthattheycause.Otherstudentsmaytakethelargerviewthattheappropriate
goalshouldbethereductionofoverallpollutionlevels,andthatcarboncreditsareawayto
achievethatgoal.Fromaninvestorstandpoint,carboncreditsallowthepollutingfirmtomeet
legalobligationsinthemostcosteffectivemanner,thusimprovingthebottomlineforthe
companyandinvestor.

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Case
Casestudiesareavailableonwww.myfinancelab.com.

Evaluating Cherone Equipments Risky Plans for Increasing Its Production


Capacity
a.

1. Plan X

CF0$2,700,000,CF1$470,000,CF2$610,000
CF3$950,000,CF4$970,000,CF5$1,500,000
SetI12%
SolveforNPV$349,715.18
PlanY
CF0$2,100,000,CF1$380,000,CF2$700,000
CF3$800,000,CF4$600,000,CF5$1,200,000
SetI12%
SolveforNPV$428,968.70

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Chapter12RiskandRefinementsinCapitalBudgeting273

2. Usingafinancialcalculator,theIRRsare:
IRRX16.22%
IRRY18.82%
BothNPVandIRRfavorselectionofProjectY.TheNPVislargerby$79,254
($428,969$349,715)andtheIRRis2.6%higher.
b.

Plan X

CF0$2,700,000,CF1$470,000,CF2$610,000
CF3$950,000,CF4$970,000,CF5$1,500,000
SetI13%
SolveforNPV$261,105.40
PlanY
CF0$2,100,000,CF1$380,000,CF2$700,000
CF3$800,000,CF4$600,000,CF5$1,200,000
SetI15%
SolveforNPV$225,412.37
TheRADRNPVfavorsselectionofProjectX.
Ranking
Plan

NPV

IRR

RADRs

c.

Both NPV and IRR achieved the same relative rankings. However, making risk adjustments through the
RADRs caused the ranking to reverse from the nonrisk-adjusted results. The final choice would be to select
Plan X since it ranks first using the risk-adjusted method.

d.

Plan X

Valueofrealoptions0.25$100,000$25,000
NPVstrategicNPVtraditionalValueofrealoptions
NPVstrategic$261,105.40$25,000$286,105.40
PlanY
Valueofrealoptions0.20$500,000$100,000
NPVstrategicNPVtraditionalValueofrealoptions
NPVstrategic$225,412.37$100,000$325,412.37
e.

With the addition of the value added by the existence of real options, the ordering of the projects is reversed.
Project Y is now favored over Project X using the RADR NPV for the traditional NPV.

f.

Capital rationing could change the selection of the plan. Since Plan Y requires only $2,100,000 and Plan X
requires $2,700,000, if the firms capital budget was less than the amount needed to invest in Project X, the firm
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274Gitman/ZutterPrinciplesofManagerialFinance,Thirteenth Edition

would be forced to take Y to maximize shareholders wealth subject to the budget constraint.

Spreadsheet Exercise
TheanswertoChapter12sIsisCorporationspreadsheetproblemislocatedontheInstructorsResource
Centeronthetextbookscompanionwebsiteatwww.pearsonhighered.com/ircundertheInstructorsManual.

Group Exercise
Groupexercisesareavailableonwww.myfinancelab.com.
Riskwithinlongterminvestmentdecisionsisthetopicofthischapter.Theinvestmentprojectsofthe
previoustwochapterswillnowhaveriskvariablesintroduced.Thecashflowsestimatedpreviouslywill
nowbecharacterizedbyalackofcertainty.Eachestimateddollarflowisnowassignedthreepossible
levelsforthreepossiblestatesoftheworlds:pessimistic,mostlikelyandoptimistic.Originalestimates
serveasthemostlikelyvalueandtheothersareplacedaroundthisvalue.
Analysisoftheseestimatesbeginswithacalculationoftherangesforeachoutcome.AsimplifiedRADR
isthencalculatedusingthepreviouslydetermineddiscountrate.TheriskadjustedNPVisthencalculated.
Thefinaltaskistocompletethisthreechapterodyssey.
UsinginformationfromChapters10,11,and12,thegroupsareaskedtodefendtheirchoiceofinvestment
projects.Aspointedoutintheassignment,groupsshouldusethisassignmenttodefendtheirchoicesinthe
formofdocumentsaspresentedtotheirboardofdirectors.Thisconclusionshouldsummarizeallthework
doneacrossthechaptersandstudentsshouldtakeprideinthequantityoftheireffort.Itworkswelltohave
eachstudentgrouppresenttheirprojectanddecisiontotheremainderoftheclass,whocanbeviewedasa
boardofdirectors.

Integrative Case 5: Lasting Impressions Company


IntegrativeCase5involvesacompletelongterminvestmentdecision.TheLastingImpressionsCompany
isacommercialprinterfacedwithareplacementdecisioninwhichtwomutuallyexclusiveprojectshave
beenproposed.Thedataforeachpresshavebeendesignedtoresultinconflictingrankingswhenconsidering
theNPVandIRRdecisiontechniques.Thecaseteststhestudentsunderstandingofthetechniquesaswell
asthequalitativeaspectsofriskandreturndecisionmaking.
a.

1.

Calculation of initial investment for Lasting Impressions Company:

PressA

PressB

Installedcostofnewpress
Costofnewpress

Installationcosts

$830,000

$640,000

40,000

20,000

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Chapter12RiskandRefinementsinCapitalBudgeting275

Totalcostnewpress

$870,000

$660,000

Aftertaxproceedssaleofoldasset

Proceedsfromsaleofoldpress

420,000

420,000

121,600

121,600

Taxonsaleofoldpress*

Totalproceedssaleofoldpress

(298,400)

Changeinnetworkingcapital**

Initialinvestment
*

Saleprice

$420,000

Bookvalue

116,000

Gain

$304,000

Taxrate(40%)

90,400

$662,000

$361,600

121,600

Bookvalue$400,000[(0.200.320.19)$400,000]$116,000
**

Cash

$25,400

Accountsreceivable

120,000

Inventory

(20,000)

Increaseincurrentassets

$125,400

Increaseincurrentliabilities

(35,000)

Increaseinnetworkingcapital

$90,400

2. Depreciation
Year

Cost

Rate

Depreciation

$870,000

0.20

$174,000

870,000

0.32

278,400

870,000

0.19

165,300

870,000

0.12

104,400

870,000

0.12

104,400

870,000

0.05

43,500

PressA
1

(298,400)

$870,000

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PressB
1

$660,000

0.20

$132,000

660,000

0.32

211,200

660,000

0.19

125,400

660,000

0.12

79,200

660,000

0.12

79,200

660,000

0.05

33,000
$660,000

ExistingPress
1
$400,000

0.12(Yr.4)

$48,000

400,000

0.12(Yr.5)

48,000

400,000

0.05(Yr.6)

20,000

0
$116,000

Operatingcashinflows

Year

Earnings
before
Depreciation
andTaxes

Depre
ciation

Earnings Earnings
before
after
Taxes
Taxes

Old
Cash
Flow

Cash
Flow

Existing
Press
1

$120,000

$48,000

$72,000

$43,200

$91,200

120,000

48,000

72,000

43,200

91,200

120,000

20,000

100,000

60,000

80,000

120,000

120,000

72,000

72,000

120,000

120,000

72,000

72,000

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Incre
mental
Cash
Flow

Chapter12RiskandRefinementsinCapitalBudgeting277

PressA
1

$250,000

$174,000

$76,000

$45,600

$219,600

$91,200 $128,400

270,000

278,400

8,400

5,040

273,360

91,200

182,160

300,000

165,300

134,700

80,820

246,120

80,000

166,120

330,000

104,400

225,600

135,360

239,760

72,000

167,760

370,000

104,400

265,600

159,360

263,760

72,000

191,760

43,500

43,500

26,100

17,400

17,400

Earnings
before
Depreciation
andTaxes

Depre
ciation

$210,000

$132,000

$78,000

$46,800

$178,800

$91,200 $87,600

210,000

211,200

1,200

720

210,480

91,200 119,280

210,000

125,400

84,600

50,760

176,160

80,000 96,160

210,000

79,200

130,800

78,480

157,680

72,000 85,680

210,000

79,200

130,800

78,480

157,680

72,000 85,680

33,000

33,000

19,800

13,200

0 13,200

Year

Earnings Earnings
before
after
Taxes
Taxes

Incre
mental
Cash
Flow

Old
Cash
Flow

Cash
Flow

PressB

3. Terminalcashflow
PressA

PressB

Aftertaxproceedssaleofnewpress
Proceedsonsaleofnewpress

$400,000

$330,000

Taxonsaleofnewpress*

(142,600)

(118,800)

Totalproceedsnewpress

$257,400

$211,200

Aftertaxproceedssaleofoldpress
Proceedsonsaleofoldpress
Taxonsaleofoldpress**

(150,000)

(150,000)

60,000

60,000

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Totalproceedsoldpress

(90,000)
90,400

$257,800

$121,200

Changeinnetworkingcapital
Terminalcashflow

PressB

PressA
Saleprice

$400,000

Less:Bookvalue(Yr.6)
Gain

0.40

Tax

$142,600

Saleprice

Taxrate
Tax

Saleprice
Less:Bookvalue(Yr.6)
Gain
Taxrate
Tax

$150,000

Less:Bookvalue(Yr.6)
Gain

43,500
$356,500

Taxrate

**

(90,000)

0
$150,000
0.40
$60,000

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$330,000
33,000
$297,000
0.40
$118,800

Chapter12RiskandRefinementsinCapitalBudgeting279

CashFlows
Year

PressA

PressB

($662,000)
$128,400

($361,600)
$87,600

182,160

119,280

166,120

96,160

167,760

85,680

5*

449,560

206,880

Initialinvestment
1

Year5

PressA

PressB

Operatingcashflow

$191,760

$85,680

Terminalcashinflow

257,800

121,200

Total

$449,560

$206,880

b.

PressA

c.

Relevant cash flow

CumulativeCashFlows
Year

PressA

PressB

$128,400

$87,600

310,560

206,880

476,680

303,040

644,440

388,720

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1,094,000

595,600

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Chapter12RiskandRefinementsinCapitalBudgeting281

1. PressA: 4years[(662,000644,440)191,760]
Payback 4(17,560191,760)
Payback 4.09years
PressB: 3years[(361,600303,040)85,680]
Payback 3(58,56085,680)
Payback 3.68years
2. PressA
CF0$662,000,CF1$128,400,CF2$182,160,CF3$166,120,
CF4$167,760,CF5$449,560
SetI14%
SolveforNPV$35,738.82
PressB
CF0$361,600,CF1$87,600,CF2$119,280,CF3$96,160,
CF4$85,680,CF5$206,880
SetI14%
SolveforNPV$30,105.88
3. IRR:
PressA: 15.8%
PressB: 17.1%
d.

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DataforNPVProfile
NPV
DiscountRate

PressA

PressB

0%

$432,000

$234,000

14%

35,455

29,953

15.8%

17.1%

Whenthecostofcapitalisbelowapproximately15%.PressAispreferredoverPressB,
whileatcostsgreaterthan15%,PressBispreferred.Sincethefirmscostofcapitalis14%,
conflictingrankingsexist.PressAhasahighervalueandisthereforepreferredoverPressB
usingNPV,whereasPressBsIRRof17.1%causesittobepreferredoverPressA,whose
IRRis15.8%usingthismeasure.
e.

a.

If the firm has unlimited funds, Press A is preferred.

b. Ifthefirmissubjecttocapitalrationing,PressBmaybepreferred.
f.

The risk would need to be measured by a quantitative technique such as certainty equivalents or risk-adjusted
discount rates. The resultant NPV of Press A could then be compared to the risk-adjusted NPV of Press B and a
decision made.

2012PearsonEducation,Inc.PublishingasPrenticeHall