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**Risk and Refinements in Capital Budgeting
**

Instructor’s Resources

Overview

Chapters 8 and 9 developed the major decision-making aspects of capital budgeting. Cash flows and budgeting models have been integrated and discussed in providing the principles of capital budgeting. However, there are more complex issues beyond those presented. Chapter 10 expands capital budgeting to consider risk with such methods as scenario analysis and simulation. Capital budgeting techniques used to evaluate international projects, as well as the special risks multinational companies face, are also presented. Additionally, two basic risk-adjustment techniques are examined: certainty equivalents and risk-adjusted discount rates. The chapter includes several examples regarding the application of risk-based refinements when capital budgeting in their professional and personal life.

Study Guide

There are no particular Study Guide examples suggested for classroom presentation.

Suggested Answer to Chapter Opening Critical Thinking Question

The State of Mississippi has considered legislation that would require State Farm to continue to issue new policies. How might that affect the premiums of current policyholders? The proposed legislation would almost certainly result in increased premiums for current and new policyholders in the absence of mandatory price controls. An insurance company will endeavor to pass on the increased risk in an uncertain environment to its policyholders. Unlike life insurance, in which policyholders can purchase certain policies that lock rates in for the duration of the policy, property and casualty policies must be renewed semiannually or annually, with opportunities for increased rates at each renewal.

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 firm’s 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.

Chapter 10

Risk and Refinements in Capital Budgeting

249

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 inflowthe level of cash inflow necessary in order for the project to be acceptablemay 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 firm’s 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. Simulation is a statistically based approach using random numbers to simulate various cash flows associated with the project, calculating the NPV or internal rate of return (IRR) on the basis of these cash flows, and then developing a probability distribution of each project’s rate of returns based on NPV or IRR criterion. 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 project’s cash flows are denominated will reduce the project’s future cash flows. If the value of the dollar depreciates relative to that currency, the dollar value of the project’s 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. Political risk, the risk that a foreign government’s actions will adversely affect the project, makes international projects particularly risky, because it cannot be predicted in advance. To take this risk into account, managers should either adjust expected cash flows or use risk-adjusted discount rates when performing the capital budgeting analysis. Adjustment of cash flows is the preferred method. Tax laws differ from country to country. Because only after-tax cash flows are relevant for capital budgeting decisions, managers must account for all taxes paid to foreign governments and consider the effect of any foreign tax payments on the firm’s U.S. tax liability. Transfer pricing refers to the prices charged by a corporation’s subsidiaries for goods and services traded between them; the prices are not set by the open market. In terms of capital budgeting decisions, managers should be sure that transfer prices accurately reflect actual costs and incremental cash flows. MNCs cannot evaluate international capital projects from only a financial perspective. The strategic viewpoint often is the determining factor in deciding whether or not to undertake a project. In fact, a project that is less acceptable on a purely financial basis than another may be chosen for strategic reasons. Some reasons for MNC foreign investment include continued market access, the ability to compete with local companies, political and/or social reasons (for example, gaining favorable tax treatment in exchange for creating new jobs in a country), and achievement of a particular corporate objective such as obtaining a reliable source of raw materials.

4. a.

b.

c.

d.

e.

5. Risk-adjusted discount rates (RADRs) reflect the return that must be earned on a given project in order to adequately compensate the firm’s owners. The relationship between RADRs and the capital asset pricing model (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.

7. such as being able to reconfigure a machine to accept various types of inputs. Twelfth Edition 6. Real options are opportunities embedded in real assets that are part of the capital budgeting process. RADRs are most often used in practice for two reasons: (1) financial decision makers prefer using rate of return-based criteria. NPVstrategic = NPVtraditional + Value of real options 11. Managers have the option of implementing some of these opportunities to alter the cash flow and risk of a given project. nj 9. However. Examples of real options include: Abandonment—the option to abandon or terminate a project prior to the end of its planned life. 10. capital rationing should not exist because firms should accept all projects with positive NPVs or IRRs greater than the cost of capital. since unfortunately most firms do not have sufficient capital available to invest in all acceptable projects. Each project is then subjectively placed in the appropriate risk class. most firms operate with finite capital expenditure budgets and must select the best from all acceptable projects. Capital rationing is common for a firm. In practice.250 Gitman • Principles of Managerial Finance. Timing—the ability to determine the exact timing of when various action of the project will be undertaken. the risk of a capital budgeting project should be considered independently rather than in terms of their impact on the total portfolio of assets. 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. risk is subjectively categorized into classes. expand markets. Investors themselves can more efficiently diversify their portfolio by holding a variety of stocks. Since a firm is not rewarded for diversification. In most cases. Strategic NPV incorporates the value of the real options associated with the project while traditional NPV includes only the identifiable relevant cash flows. A firm whose stock is actively traded in security markets generally does not increase in value through diversification. Growth—the option to develop follow-on projects. and so on. that would not be possible without implementation of the project that is being evaluated. In theory. Capital rationing is a situation where a firm has only a limited amount of funds available for capital investments. taking into account the amount of new financing required to fund these projects. In practice. each having a RADR assigned to it. implementation of the acceptable projects would require more capital than is available. Flexibility—the ability to adopt a project that permits flexibility in the firm’s production process. A comparison of NPVs of unequal-lived mutually exclusive projects is inappropriate because it may lead to an incorrect choice of projects. The expression used to calculate the ANPV follows: ANPV = NPVj PVIFAr %. 8. 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. and (2) they are easy to estimate and apply. management usually follows this approach and evaluates projects based on their total risk. expand or retool plants. . Using strategic NPV could alter the final accept/reject decision.

any sound evaluation of a project will eventually require such information gathering before a decision can be made. Some factors to consider when prioritizing and budgeting environmental compliance initiatives include the regulatory costs of noncompliance. For example. and municipalities. marketing costs. consumer products. But even beyond the quick analysis of the effect of changing a project variable is that the need for accurate and reasonable estimates will force project developers to spend some time and effort to develop the proper data for input into the Monte Carlo program. manufacturing. The benefit of the NPV approach is that it guarantees a maximum dollar return to the firm. associated overhead. Gathering this type of data for numerous projects can be expensive in terms of employee-hours.48 Most Likely $6.99 Optimistic $15. 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. However. the cost of product recalls. retail. the cost of repairing environmental damage. Using the IRR approach. The IRR approach and the NPV approach to capital rationing both involve ranking projects on the basis of IRRs. and other costs related to the project. production costs. Suggested Answer to Critical Thinking Question for Focus on Practice Box A Monte Carlo simulation program requires the user to first build an Excel spreadsheet model that captures the input variables for the proposed project. Answer: Using the 12% cost of capital to discount all of the cash flows for each scenario to yield the following NPVs. the effect on possible sales outcome can be quickly demonstrated. Working diligently to find reliable cost estimates and marketing estimates can only enhance the viability of a proposed project if it meets the company’s selection criteria.109. and service industries. if the marketing variable is increased. and the degree to which suppliers.826.283. With increased consumer awareness. customers. including projected sales figures. resulting in a NPV range of $19. Answers to Warm-Up Exercises Sensitivity analysis E10-1. What issues and what benefits can the user derive from this process? A good Monte Carlo simulation requires reasonably accurate estimates of data.78: Pessimistic −$3. the brand opportunity of active environmental compliance. and competitors are investing in environmental compliance.Chapter 10 Risk and Refinements in Capital Budgeting 251 12.516. Suggested Answer to Critical Thinking Question for Focus on Ethics Box What are some factors to consider when prioritizing and budgeting environmental compliance initiatives? Environmental compliance has become a core competency for chemical manufacturers. whereas the IRR approach does not. utilities. The benefit of the Monte Carlo program is that it can quickly provide a range of probable outcomes as the potential inputs are varied. a cut-off rate and a budget constraint are imposed.30 . it is rapidly becoming a core competency required in food and beverage. environmental compliance can give a company a competitive advantage over its competitors. In this era of environmental awareness.

22 Project N Step 1: Find the NPV of the project Step 2: NPV = $13.993 = $11. . you should advise Outcast. Risk-adjusted discount rates Answer: Project Sourdough RADR = 7. E10-4.82 Find the ANPV PV N I = −13. to choose Project M. Using IRR as selection criteria Answer: The minimum amount of annual cash inflow needed to earn 8% is $11. Since the required cash flow is much less than the anticipated cash flow.252 Gitman • Principles of Managerial Finance.24 Based on ANPV.270 45. one would expect the IRR to exceed the required rate of return. Inc.288.360 =3 =8 PMT = $8.0% NPV $17.05%.235.48 Yeastime should select Project Sourdough.09 Project Greek Salad RADR = 8.270.000/PVIFA8%. Twelfth Edition E10-2. Project M Step 1: Find the NPV of the project Step 2: NPV = $21.5 $45.235. The project is acceptable since its IRR exceeds the firm’s 8% cost of capital.72 Calculator solution = $11. Choose the project with the higher IRR.54 The IRR of the project is 12.325.0% NPV $13.269. E10-3.359.55 Find the ANPV PV N I = −21.141. ANPV Answer: You may use a financial calculator to determine the IRR of each project.000/3.82 =7 =8 PMT = $2.542.

136. The total investment in these three projects will be $135.66) CF = $6. their commitment at this time is low. .183.72 The required cash flow per year would decrease by $1. Although this purchase is in the industry in which Caradine normally operates.000 = CF(5. The large expenditure. The competitive nature of the industry makes it so that Caradine will need to make this expenditure to remain competitive.12) $35.75 Calculator solution: $6.48 Calculator solution: $5. $35.12) $35.136.Chapter 10 Risk and Refinements in Capital Budgeting 253 E10-5. P10-2. However. $35. LG 2: Breakeven cash flows Intermediate a. the $450. the competitiveness of the industry.000 is a large sum of money for the company and it will immediately become a sunk cost.000 = CF(6.27. NPV profiles Answer: The investment opportunity schedule (IOS) in this problem does not allow us to determine the maximum NPV allowed by the budget constraint. In order to determine whether the IOS maximizes the NPV for Longchamps Electric. Since the firm is only preparing a proposal.43 b. it does appear likely that Longchamps Electric will maximize firm value by selecting Project 4 (IRR =11%). The risk is only moderate since the firm already has clients in place to use the new technology. LG 1: Recognizing risk Basic a&b Project A Risk Low Reason The cash flows from the project can be easily determined since this expenditure consists strictly of outflows.000 = CF(PVIFA10%.000. B Medium C Medium D High Note: Other answers are possible depending on the assumptions a student may make. and Project 5 (IRR = 9%). Solutions to Problems P10-1.814) CF = $5. leaving $15. There is too little information given about the firm and industry to establish a definitive risk analysis.000 excess cash for future investment opportunities. and the political and exchange risk of operating in a foreign country adds to the uncertainty.000 = CF(PVIFA14%. we will need to know the NPV for each of the six projects. they are encountering a large amount of risk. Project 2 (IRR = 10%). However. The amount is also relatively small.047.183.

520 NPV = $10.621. NPV Project A Outcome Pessimistic Most likely Optimistic Range c.56 7.352) PVn = $50.) .297 514 7. P10-4.254 Gitman • Principles of Managerial Finance.622 Calculator Solution −$ 6.520 NPV = PVn − initial investment NPV = PVn − initial investment NPV = $33. Twelfth Edition P10-3.000 NPV = $3.702 Project B Calculator Solution −$ 337.000 NPV = $50. thus the risk–return tradeoff. to achieve higher NPV.280 − $40.600 Range B = $1. Choose Project X to minimize losses.280 PVn = $33.520 − $30. Project Y is more risky and has a higher potential NPV.949. Project X Project Y PVn = PMT × (PVIFA15%.92 $1.000 ÷ 3.29 513.56 1. e.33 b.5 yrs. (A is more risky than B but also has the possibility of a greater return.71 Since the initial investment of Projects A and B are equal.800 − $200 = $1.365 $1. Table Value −$ 6.352 = $40.280 Calculator solution: $3.62 c. LG 2: Basic scenario analysis Intermediate a.324.) PVn = $15.55 Calculator solution: $10. choose Project Y.70 Table Value −$ 337 514 1.352 $CF = $40.5 yrs.17 Calculator solution: $8. Project X has less risk and less return while Project Y has more risk and more return.521.79 513.325 $13.000 × (3.352) PVn = $10.) PVn = PMT × (PVIFA15%.297. LG 2: Breakeven cash inflows and risk Intermediate a.100 − $900 = $200 b. d. Range A = $1. Project X Project Y Probability = 60% Probability = 25% d.932.000 ÷ 3. Project selection would depend upon the risk disposition of the management.000 × (3.47 Calculator solution: $11.88 $CF = $11. the range of cash flows and the range of NPVs are consistent.949. Project X Project Y $CF × 3.364.933.000 $CF = $30.41 $13.352 = $30.702.352 $CF = $8.000 $CF × 3.282.

0000 0.896 1.7651 Higher Lower Current Inflation Inflation NPV (a) NPV (b) NPV (c) (7.7299 Higher Inflation PVIF (7.17 1.8653 0.500 Current Rate PVIF (6.731 1. Therefore.145 − $73 = $3.9390 0.9302 0.6966 Lower Inflation PVIF (5.123 1.7773 0. LG 2: Scenario analysis Intermediate a.608.145 Calculator Solution $72.763 1.915.000 1.072.7488 0.797 1.43 3.609 4.8985 0.29) Range Q = $4. NPV Project P Outcome Pessimistic Most likely Optimistic c. By tying various cash flow assumptions together into a mathematical model and repeating the process numerous times.500) 1. Table Value $73 1.65) Each computer has the same most likely result.500) 1.374 − (−$542) = $4.148 $ 254 Year 0 1 2 3 4 5 Total NPV d.8516 0.860 1. As the inflation rate rises the NPV of a given set of cash flows declines. P10-7.57 Table Value −$542 1.609 3. The process of generating random numbers and using the probability distributions for cash inflows and outflows allows values for each of the variables to be determined.878 1. The use of the computer also allows for more sophisticated .50%) 1.072 (Calculator solution: $3.000 − $500 = $500 Range Q = $1.373.28 1.500 1.43 4.5%) 1.608. Computer Q has both a greater potential loss and a greater potential return. a probability distribution of project returns can be developed.50%) 1.500) 2.8817 0.9479 0.045 $ (131) (7.144.916 (Calculator solution: $4.0000 0.095 $ 58 (7. Range P = $1.48 Range P = $3.8050 0.211 1.0000 0.8072 0.703 1.610 1. the decision will depend on the risk disposition of management.500) 1.656 1. Ogden Corporation could use a computer simulation to generate the respective profitability distributions through the generation of random numbers.Chapter 10 Risk and Refinements in Capital Budgeting 255 P10-5.374 Project Q Calculator Solution −$542.000 2. LG 2: Simulation Intermediate a.8278 0.200 − $400 = $800 b.166 1. P10-6 LG2: Impact of inflation on investments Easy (a) − (c) Investment Cash Flows (7.000 2.

80 × (0.130 − $15.87 Project F Year 1 2 3 4 CF $6.29 Project E.864 $20. Project E PVn = $6.10 + (1.129. The key lies in formulating a mathematical model that truly reflects existing relationships.000 × (PVIFA15%. The advantages to computer simulations include the decision maker’s ability to view a continuum of risk–return tradeoffs instead of a single-point estimate.024 3.572 PV $ 5. b.256 Gitman • Principles of Managerial Finance.15 − 0.4) PVn = $6.870 0.144 $12.144 NPV = $20.756 0.000 2.678 Calculator solution: $1. The computer simulation.000 × 2. Substitution of these values into the mathematical model yields the NPV. P10-8. LG 4: Risk–adjusted discount rates–Basic Intermediate a.n 0.658 0. however.855 PVn = $17.000 5. is not feasible for risk analysis.13 .000 NPV = $1.130 Calculator solution: $2.673.000 6. RADRE = 0.05 Project G Year 1 2 3 4 CF $4.000 PVIF15%.658 0.870 0.000 NPV = $1.220 3.000 8.130 NPV = $17.10 + (1.000 PVIF15%.60 × (0.00 × (0.480 4. Twelfth Edition simulation using components of cash inflows and outflows.144 − $19.678 − $11.n 0.000 12.000 4.10 + (0.19 RADRF = 0.136. is preferred.10)) = 0.15 − 0.144 Calculator solution: $1.10)) = 0.15 − 0.000 NPV = $2.678 NPV = $12.10)) = 0. b. with the highest NPV.264 6.572 PV $ 3.15 RADRG = −0.290 1.756 0.536 5.

356 $21.05) Project G Year 1 2 3 4 CF $4.678 (Calculator solution: $1.05) Project G Year 1 2 3 4 CF $4.000 NPV = $834 Calculator solution: $831.613 PV $3.639) = $15.000 12.19 RADRF = 0.000 PVIF13%.15 − 0.000 12.673. $1.000 NPV = $834 Calculator solution: $831.540 4.834 NPV = $15.10 + (0.000 PVIF13%.10)) = 0.834 − $15.693 0.613 PV $ 3.15 RADRG = −0.000 8.885 0.10 + (1. Project E $6.783 0.678 (Calculator solution: $1.885 0.60 × (0.693 0.783 0.51 Project F Same as in part a.80 × (0.15 − 0.000 × (2.n 0. Project E $6.15 − 0.10)) = 0.544 7. $1.639) = $15.540 4.698 5.698 5. RADRE = 0.138 NPV = $21.n 0.000 6.000 8.142.000 × (2.10)) = 0.138 .138 − $19.Chapter 10 Risk and Refinements in Capital Budgeting 257 c.834 NPV = $15.673.93 Rank 1 2 3 Project G F E b.000 NPV = $2.544 7.10 + (1.51 Project F Same as in part a.356 $21.000 6.138 Calculator solution: $2.00 × (0.834 − $15.13 c.

000 3. Year 0 1 2 3 4 5 Cash Flows $ (12.97 NPVB = ($10.93 Rank 1 2 3 Project G F E d.951 (Use 8% rate) Calculator solution: $7.7829 0.822 .548 2.000 NPVA = $7. After adjusting the discount rate.000 PVIF @ 8.000 3.800 3.8495 0.7412 0.000) 3.330 (Use 14% rate) Calculator solution: $4. with the higher NPV.816 2.800 3.8190 0.000) 2.000 × 3. should be chosen.7216 0.000 NPV = $2.000 3.349 2.223 Cash Flows $ (10.81 Project A. LG 4: Risk–adjusted discount rates–tabular Intermediate a.948.549 2. Project G has the highest NPV and should be chosen. LG 4: Mutually exclusive investment and risk Intermediate a.800 PVIF @ 8.112 2.000) 3.307 $ 2.000 × 3.6650 NPV $ (10.9050 0. even though all projects are still acceptable. b.993) − $20. P10-10.439 3.995 $ 1.0000 0. since the NPV of A is greater than the NPV of B.9217 0.138 − $19.443) − $30.142. NPVA = ($7.000 3.765 2.6070 NPV $ (12.138 Calculator solution: $2.5% 1. Year 0 1 2 3 4 5 b. Twelfth Edition NPV = $21.6707 0.165 1.330.000) 3.0000 0.800 3. P10-9.258 Gitman • Principles of Managerial Finance.000 NPVB = $4. the ranking changes.5% 1. Project A is preferable to Project B.800 3.

The RADR approach prefers Project Y over Project X.220 Calculator solution: $19. Lara should select the second investment.805.592) − $78.451 0.551 0.877) + $32.650 + $27.885 0.000(PVIF14%.000 60.783 0.232 − 78.200 $194.613 0. The RADR approach is most often used in business.000 NPVX = $30.980 48.000(0.600 47.675) + $46.820 0.000 60.250 46. d.n 0.2) + $38. The higher required return implies a higher risk factor. It has a higher NPV.769) + $38.Chapter 10 Risk and Refinements in Capital Budgeting 259 c.2(12% − 7%) = 7% + 6% = 13% rY = 7% + 1.000 90.000(PVIF14%3) + $46.693 0.510 49.960 Calculator solution: $14.82 b.4) − $78.370 PV $ 65.000 70.060 27.000 70.974) − $70.000(PVIFA13%.960 − $180.4) − $70.930.45 Project Y Year 1 2 3 4 5 CF $50.543 PV $ 44.1) + $32.060 22.000 NPVY = $22.000 60.672 0.82 Calculator solution: $18.000(0.000 PVIF13%. P10-12. The second investment is riskier.650 .000 NPV = $14. rX = 7% + 1.608 + $25.960 NPV = $194.040 33.000(2.000 = $18.040 48.14 NPVY = $22.000(PVIF14%. LG 4: Risk-adjusted rates of return using CAPM Challenge a. The RADR approach combines the risk adjustment and the time adjustment in a single value.000(0.234.000 NPVY = $19.000 60.000 NPVX = $89.000(PVIF14%.000(0. LG 4: Risk classes and RADR Basic a.870 $237. Project X Year 1 2 3 4 5 CF $80.000 PVIF22%.4(12% − 7%) = 7% + 7% = 14% NPVX = $30.805. P10-11.n 0.000 = $19.294 + $24.000 80. Using NPV as her guide.220 − $70.

111) PVn = $49.000 $90.5 yrs.260 Gitman • Principles of Managerial Finance.58 Machine C PVn = PMT × (PVIFA12%.650 Calculator solution: $2.797 0. LG 5: Unequal lives–ANPV approach Intermediate a.000 40.000 NPV = $2.332 NPV = PVn − initial investment NPV = $49.670 − $65.04 b.000 30. Machine A PVn = PMT × (PVIFA12%. while Project Z with a negative NPV is not.) PVn = $30.670 NPV = $71.320 Calculator solution: −$8.352 $301.000 PVIFA15%.663.000 NPV = −$42.663.000 $90.000 $90.646.99 Project Z Year 1 2 3 4 5 CF $90.360 25. Projects X and Y are acceptable with positive NPV’s.680 − $310.000 × (4.000 $90. P10-13.650 − $235.668 Calculator solution: − $42.930 15.636 PV $8.150 .000 NPV = $6.11 Machine B Year 1 2 3 4 CF $10.000 × 3.306.605 PVn = $108.680 NPV = $301.n 0.940 21. Project X with the highest NPV should be undertaken.893 0.670 Calculator solution: $6. Twelfth Edition NPV = $237.000 NPV = −$8.000 PVIFA12%.440 $71.) PVn = $12.6 yrs.000 20.5 PV 3.712 0.332 − $92.

6 years) ANPV = −$10.32 Rank 1 2 3 c.643.378 Calculator solution: –$10.675 0.605 (12%. Project B C A Machine B should be acquired since it offers the highest ANPV.196 Calculator solution: $2.000 25.500 NPV = $7. ANPV(ANPVj ) = PVIFAk %.877 0.650 ÷ 3.650 Calculator solution: $7.668 ÷ 4.n 0. 5 years) ANPV = $2.681 NPV = $80.698.592 PV $14.000 PVIF14%.681 Calculator solution: $2.32 .000 33. Not considering the difference in project lives resulted in a different ranking based in part on Machine C’s NPV calculations.150 − $ 100.681 − $78.188. 4 years) ANPV = $2. LG 5: Unequal lives–ANPV approach Intermediate a.275 24.000 41.28 Machine C ANPV = $7.120.376.Chapter 10 Risk and Refinements in Capital Budgeting 261 NPV = PVn − initial investment NPV = $108.29 Rank 1 2 3 Machine C B A (Note that Machine A is not acceptable and could be rejected without any additional analysis.225 22.000 NPV = $2.) NPVj b. Project X Year 1 2 3 4 CF $17.122 Calculator solution: $2. P10-14.77 Machine B ANPV = $6.272 $80.111 (12%.670 ÷ 3.037 (12%.909 19.769 0. nj Machine A ANPV = −$42.

83 Project Z ANPV = $3.000 PVIF14%.585 − $66.681 ÷ 2. 4 yrs.585 Calculator solution: $3.582.) ANPV = $920.647 (14%.778 Calculator solution: $1.80 Calculator solution: $772.17 Project Z PVn = PMT × (PVIFA14%.778 ÷ 1. The results in Parts a and b show the difference in NPV when differing lives are considered.585 NPV = PVn − initial investment NPV = $69.54 Calculator solution: $1093.769 PV $24. nj ANPV (ANPVj ) = Project X ANPV = $2. Project Z X Y NPVj PVIFAr %.000 38.) PVn = $15.96 Rank 1 2 3 b. 2 yrs.38 Rank 1 2 3 c.877 0.n 0.000 NPV = $1.8 yrs.04 Calculator solution: $926.222 $53.556 29.) ANPV = $1.914 (14%. 8 yrs.000 NPV = $3.262 Gitman • Principles of Managerial Finance.) ANPV = $772. Project Y X Z Project Y should be accepted.639 PVn = $69.778 NPV = $53. Twelfth Edition Project Y Year 1 2 CF $28.639 (14%. .778 − $52.585 ÷ 4.079.000 × 4.08 Project Y ANPV = $1.801.

797 0.000 200.600 199.250 142.960 38.250 − $450.636 0. Sell Year 1 2 CF $200.250 Calculator solution: $412.n 0.400 127.704.750 NPV = $420.25 Manufacture Year 1 2 3 4 5 6 CF $200.000 PVIF12%.000 100.90 License Year 1 2 3 4 5 CF $250.400 101.250 NPV = $862.797 0.712 0.600 199.n 0.000 NPV = $220.700 56.160 22.000 60.850 Calculator solution: $177.000 200.567 PV $223.000 PVIF12%.893 0.Chapter 10 Risk and Refinements in Capital Budgeting 263 P10-15.250 79.000 80.200 113.000 200.000 NPV = $177.000 250.000 200.000 40.712 0.893 0.507 PV $178.000 250.250 $377.797 PV $178.636 0.893 0.750 Calculator solution: $220.850 − $200.000 PVIF12%.n 0.567 0.869.400 $862.850 NPV = $377.000 NPV = $412.141.680 $420.750 − $200.16 Rank 1 2 3 Alternative Manufacture License Sell . LG 5: Unequal lives–ANPV approach Intermediate a.

10 × $10.2397 0.243.750 ÷ 3.) ANPV = $100. nj Sell ANPV = $177.700 + 2. P10-16. Twelfth Edition b.000) Value of real options = $300 + $900 + $1. LG 6: Real options and the strategic NPV Intermediate a. ANPV adjusts for the differences in the length of the projects and allows selection of the optimal project.700) $ 1000 4 years $ 350 9.605 (12%.) ANPV = $61.25 × $1. P10-17.264 Gitman • Principles of Managerial Finance.111 (12%. Richard and Linda should select the Sony set because its ANPV of $243 is greater than the $94 ANPV of Samsung.245.40 Calculator solution: $61.225.33 Rank 1 2 3 c.234. 6 yrs. Alternative Sell Manufacture License License ANPV = $220.250 ÷ 4.5yrs.200 = $500 .5313 0. – b. Unequal-Life Decisions Annualized Net Present Value (ANPV) Samsung Cost Benefits Life Terminal value Required rate of return PVIFA PVIF NPV* ANPV** $ (2. Value of real options = value of abandonment + value of expansion + value of delay Value of real options = (0.0% 2.30 × $3. 2yrs.51 Comparing the NPVs of projects with unequal lives gives an advantage to those projects that generate cash flows over the longer period. LG: 5: NPV and ANPV decisions Challenge a.350) $ 900 3 years $ 400 9.0% 3.28 Manufacture ANPV = $412. ANPV (ANPVj ) = NPVj PVIFAk %.69 Calculator solution: $105.200 NPVstrategic = NPVtraditional + Value of real options = −1.74 Calculator solution: $100.) ANPV = $105.000) + (0.690 (12%.000 = $2.7084 $ 788 $ 243 * NPV = [$Benefits (PVIFA) + Terminal Value (PVIF) ** ANPV = NPV ÷ PVIFA c.236. This technique implicitly assumes that all projects can be selected again at their conclusion an infinite number of times.200) + (0.7722 $ 237 $ 94 Sony $ (2.850 ÷ 1.279.

000.000. b. Projects F and C require a total initial investment of $4.000 400.500.000 5. E.500.500.000 800. the best option is to choose Projects B.000 – $5.000.500.200. and G.000 2. Rank by IRR Project F E G C B A D IRR 23% 22 20 19 18 17 16 Initial Investment $2.000 and provide a total present value of $5.000 less present value ($5.500.400.500. c.000) than the NPV approach.200.000 and a net present value of $800. The internal rate of return approach uses the entire $4.000. Due to the added value from the options Rene should recommend acceptance of the capital expenditures for the equipment.000 4. which also use the entire capital budget and provide an NPV of $900. and therefore a NPV of $700. The firm should implement Projects B.000 1.000.Chapter 10 Risk and Refinements in Capital Budgeting 265 b. Since the NPV approach maximizes shareholder wealth.200. In general this problem illustrates that by recognizing the value of real options a project that would otherwise be unacceptable (NPVtraditional < 0) could be acceptable (NPVstrategic > 0).000 capital budget but provides $200.500.300.000 100.200. F. as explained in Part c.000 800. P10-18.000 100.000 100. it is the superior method. Rank by NPV (NPV = PV – Initial investment) Project F A C B D G E NPV $500.000 3.000 Projects F.500. while it has an acceptable NPV. and G require a total investment of $4. F.000 Initial Investment $2.000 1.000 and provide a total present value of $5. .000 300. and G. its initial investment exceeds the capital budget.000 300.000 Project A can be eliminated because. It is thus important that management identify and incorporate real options into the NPV process. However. d.000 1. c.000 800. LG 6: Capital rationing–IRR and NPV approaches Intermediate a.000.000 Total Investment $2.300.

170 676.000 PVIF12%. Ethics problem Challenge Student answers will vary.000.000 960. From an investor standpoint. F.700 .500 $3. Project A B C D E F G PV $384.000 610.567 PV $419.920 850.000 950.893 0. thus improving the bottom line for the company and investor. Case Evaluating Cherone Equipment’s Risky Plans for Increasing Its Production Capacity 1. P10-20.000 1. resulting in a total net present value of $235.000 150. and G.797 0.000 210. Other students may take the larger view that the appropriate goal should be the reduction of overall pollution levels and that carbon credits are a way to achieve that goal.712 0. Project G would be accepted first because it has the highest NPV.500.000 970.636 0. Its selection leaves enough of the capital budget to also accept Project C and Project F.000 570.n 0.000 125.266 Gitman • Principles of Managerial Finance. The optimal group of projects is Projects C.710 486.000 b. Plan X Year 1 2 3 4 5 CF $470. a.000 990.049. Twelfth Edition P10-19. Some students might argue that companies should be held accountable for any and all pollution that they cause. LG 4: Capital Rationing-NPV Approach Intermediate a. carbon credits allow the polluting firm to meet legal obligations in the most cost-effective manner.400 616.

140 ($428.400 $2.000 970.961.22% IRRY = 18.000 700.040 NPV = $2.n 0.n 0.000 NPV = $261.350 594. Plan X Year 1 2 3 4 5 CF $470.693 0.712 0.000 800.82% Both NPV and IRR favor selection of Project Y.715.200 526.840 NPV = $2.610 814.500. 2.797 0.613 0.000 950.840 − $2.700.600 381.840 − $349.600 529.700 − $2.400 343.700) and the IRR is 2.n 0.18 Plan Y Year 1 2 3 4 5 CF $380.528.6% higher.325.400 $2.700.000 1.049.497 PV $ 330.000 PVIF13%.000 1.200.756 0.000 600.885 0.000 600.200.500 $2. The NPV is larger by $79.600 680.567 PV $ 339.870 0.000 NPV = $428.Chapter 10 Risk and Refinements in Capital Budgeting 267 NPV = $3.700 Calculator solution: $349.000 610.040 Calculator solution: $261.340 557.961.200 596.543 PV $ 415.000 PVIF12%.70 b. Using a financial calculator the IRRs are: IRRX = 16.968.000 800.000 PVIF15%.658 0.950 477.572 0.000 1.630 658.40 Plan Y Year 1 2 3 4 5 CF $380.900 569.000 700.800 .105.040 − $2.000 NPV = $349.840 Calculator solution: $428.100.783 0.893 0.528.636 0.

However.000 and Plan X requires $2. Ranking Plan X Y 3. .prenhall. Capital rationing could change the selection of the plan.000 = $100. Group Exercises Risk within long-term investment decisions is the topic of this chapter.105.700.37 The RADR NPV favors selection of Project X. the firm would be forced to take Y to maximize shareholders’ wealth subject to the budget constraint.000 = $25.000 = $286. Since Plan Y requires only $2.040 Calculator solution: $286. Twelfth Edition NPV = $2. most likely and optimistic.268 Gitman • Principles of Managerial Finance. The final choice would be to select Plan X since it ranks first using the risk-adjusted method.800 Calculator solution: $225.040 + $25. The cash flows estimated previously will now be characterized by a lack of certainty.800 − $2. With the addition of the value added by the existence of real options the ordering of the projects is reversed.25 × $100.com/irc.40 Plan Y Value of real options = 0.800 + $100. Each estimated dollar flow is now assigned three possible levels for three possible states of the worlds: pessimistic. 6.412 NPVstrategic = $225. if the firm’s capital budget was less than the amount needed to invest in Project X.000 NPVstrategic = NPVtraditional + Value of real options Calculator solution: $325. Spreadsheet Exercise The answer to Chapter 10’s Isis Corporation spreadsheet problem is located in the Instructor’s Resource Center on the textbook’s companion website at www.000 NPV = $225. NPV 2 1 IRR 2 1 RADRs 1 2 Both NPV and IRR achieved the same relative rankings. Project Y is now favored over project X using the RADR NPV for the traditional NPV.20 × $500. Original estimates serve as the most likely value and the others are placed around this value.800 4. 5.412.325.000 = $325.100.000. making risk adjustments through the RADRs caused the ranking to reverse from the nonrisk adjusted results.000 NPVstrategic = NPVtraditional + Value of real options NPVstrategic = $261.100. The investment projects of the previous two chapters will now have risk variables introduced. Plan X Value of real options = 0.

9 and 10 the groups are asked to defend their choice of investment projects.prenhall.000 121.000 + Installation costs Total cost-new press − After-tax proceeds-sale of old asset = Proceeds from sale of old press 420.000 (298. a.000 * 121.400 (35.19) × $400.000 40.400 120.000 .000 $304.400) 90.600 (298. As pointed out in the assignment. The final task is to complete this three-chapter odyssey.600 $ 25. In the course of completing the assignments students access information about a firm. A Note on Web Exercises A series of chapter-relevant assignments requiring Internet access can be located at the Instructor’s Resource Center (http://www.20 + 0.000) $125.000 $870. Integrative Case 3: Lasting Impressions Company Integrative Case 3 involves a complete long-term investment decision.000) $ 90. This conclusion should summarize all the work done across the chapters and students should take pride in the quantity of their effort. The data for each press have been designed to result in conflicting rankings when considering the NPV and IRR decision techniques.400 Press B $640.Chapter 10 Risk and Refinements in Capital Budgeting 269 Analysis of these estimates begins with a calculation of the ranges for each outcome.32 +0.600 + Tax on sale of old press Total proceeds-sale of old press ** + Change in net working capital Initial investment * Sale price − Book value Gain × Tax rate (40%) Cash Accounts receivable Inventory Increase in current assets Increase in current liabilities Increase in net working capital $420.000 420.000 ** . The case tests the students’ understanding of the techniques as well as the qualitative aspects of risk and return decision making. Using information from Chapters 8.000] = $116.000 $660.400) 0 $361. and conduct analyses consistent with those found in each respective chapter. 1. A simplified RADR is then calculated using the previously-determined discount rate.000 (20.000 121.[(0. Calculation of initial investment for Lasting Impressions Company: Press A Installed cost of new press = Cost of new press $830.400 $662. The Lasting Impressions Company is a commercial printer faced with a replacement decision in which two mutually exclusive projects have been proposed.000 116.600 Book value = $400.com/gitman). groups should use this assignment to defend their choices in the form of documents as presented to their board of directors. its industry.000 20. and the macro economy. The risk-adjusted NPV is then calculated.

360 −26.820 135.000 660.000 20.000 0 $48.000 330.000 −8.20 0.05 0.000 72.700 225.200 43.000 660.000 120.200 80.760 72.000 72.270 Gitman • Principles of Managerial Finance.100 $91.000 120.400 . Twelfth Edition b.000 $660. 5) 0.05 Depreciation $174.000 660.200 125.000 660.400 91.600 −5.000 870.000 0 $45.600 265.400 $91.760 0 17.000 300.19 0.000 20.400 165.000 278.000 0 $76.000 72.400 104.000 191.12 0.300 104.000 $132.000 870.000 0 $219.000 3 400.20 0.760 17.05 (Yr. Depreciation Year Press A 1 2 3 4 5 6 Press B 1 2 3 4 5 6 Cost $870.600 −43.000 48.000 120.200 60.12 0.000 0 0 0 $174.000 0 0 0 $116.12 (Yr.12 0.000 167.200 91. 6) 0 0 0 Year Existing Press 1 2 3 4 5 6 Press A 1 2 3 4 5 6 Depreciation Earnings Earnings before after Taxes Taxes Cash Flow Old Cash Flow Incremental Cash Flow $120.200 $128.000 870.000 48.12 (Yr.000 120.000 $660.040 80.000 4 0 5 0 6 0 Operating cash inflows Earnings before Depreciation and Taxes 0.12 0.000 278.120 72.500 $72.600 273.200 182. 4) 0.000 72.000 870.360 159.400 43.000 2 400.400 104.400 165.400 79.000 270.500 $870.500 $43.000 120.000 0 $250.000 72.19 0.000 870.000 211.000 660.360 246.120 239.32 0.200 79.400 134.000 Rate 0.160 80.000 Existing Press 1 $400.400 43.200 33.760 263.000 120.32 0.300 104.000 370.000 100.000 $48.000 166.

000 43.680 0 13.40 $118.200 33.280 80.40 $142.800 130.680 157.000 (142.480 −19.000 0 $132.760 78.680 72.200 84.000) 60.480 176.000) 90.000 (118.600 91.480 78.200 Terminal cash flow Press A After-tax proceeds-sale of new press = Proceeds on sale of new press * Tax on sale of new press Total proceeds-new press − After-tax proceeds-sale of old press = Proceeds on sale of old press ** + Tax on sale of old press Total proceeds-old press + Change in net working capital Terminal cash flow *Press A Sale price Less: Book value (Yr.000 85.800 210.000 × 0.000 210.000 × 0.200 79.000 96.500 $356. Earnings before Depreciation and Taxes Depreciation Earnings Earnings before after Taxes Taxes Cash Flow Old Cash Flow Incremental Cash Flow $210.000 −1.200 (150.000 210.200119.400 79.000 $46.800) $257.160 72. 6) Gain Tax rate Tax Press B $330.400 $257.000 (90.000) 60.600) (150.800 −720 50.000 33.500 × 0.400 $211.000) 0 $121.000 $78.800 .40 $ 60.200 $91.000 0 $150.000 85.800 −33.800 $178.160 157.800 (90.Chapter 10 Risk and Refinements in Capital Budgeting 271 Year Press B 1 2 3 4 5 6 c. 6) Gain Tax rate Tax $330.000 211.680 13. 6) Gain Tax rate Tax **Sale price Less: Book value (Yr.000 $400.600 130.000 $297.000 210.200$87.200 $400.000 Press B Sale price Less: Book value (Yr.200 125.000 210.600 $150.

560 Press A $191.680 121.280 96.680 644.160 166.400 310.600 119.160 85.000 Press B $87.600 .720 595.880 303.680 206.040 388.272 Gitman • Principles of Managerial Finance.600 206.880 Press B $ 85.600) $ 87.800 $449.400 182.760 257. Press A 3.560 476.560 Press B ($361.094. Relevant cash flow Cumulative Cash Flows Year 1 2 3 4 5 Press A $128.200 $206.760 449. Twelfth Edition Cash Flows Year Initial investment 1 2 3 4 5* * Press A ($662.880 Year 5 Operating cash flow Terminal cash inflow Total 2.000) $128.440 1.120 167.

000 − 644.953 Calculator solution: $30.553 NPV = $391.760] Payback = 4 + (17.455 Calculator solution: $35.314 233.769 0.880 PVlF14%. IRR: Press A: 15.82 Press B Year 1 2 3 4 5 Cash Flow $87. Press A Year 1 2 3 4 5 Cash Flow $128.675 0.769 0.877 0.000 NPV = $35.455 NPV = $697.600 119.131 99.760) Payback = 4.680] Payback = 3 + (58.908 50.600 − 303.455 − $662.68 years b.680) Payback = 3.592 0.t 0.Chapter 10 Risk and Refinements in Capital Budgeting 273 a.160 85.760 449.105.877 0.120 167.371 $391.09 years Press B: 3 years + [(361.723 107.400 182.680 206.88 c.1% .726 64.560 PVlF14%.t 0.592 0.600 NPV = $29.738. Press A: 4 years + [(662.607 140.675 0.160 166.553 − $361.519 PV $ 76.040) ÷ 85.322 $697.560 ÷ 85.8% Press B: 17.440) ÷ 191.560 ÷ 191.081 112.519 PV $112.825 91.280 96.

Press A has a higher value and is therefore preferred over Press B using NPV. b. 5.953 — 0 When the cost of capital is below approximately 15 percent. If the firm has unlimited funds. . Press A is preferred over Press B. whose IRR is 15. while at costs greater than 15%.1% NPV Press A Press B $432. a. If the firm is subject to capital rationing.8% 17. whereas Press B’s IRR of 17.274 Gitman • Principles of Managerial Finance. The risk would need to be measured by a quantitative technique such as certainty equivalents or riskadjusted discount rates. Press B may be preferred.8% using this measure. conflicting rankings exist. Twelfth Edition 4. Press A is preferred.000 35. 6. Since the firm’s cost of capital is 14%. Data for NPV Profile Discount Rate 0% 14% 15. Press B is preferred.000 29. The resultant NPV of Press A could then be compared to the risk-adjusted NPV of Press B and a decision made.455 0 — $234.1% causes it to be preferred over Press A.

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