POTFOLIO EFFECTS

BOGNOT, TRACY M.
BSA-3B
PORTFOLIO – a collection of assets.
DIVERSIFICATION – combining negatively
correlated assets to reduce or diversify risk.
NEGATIVE CORRELATION – describes a
relationship between two variables that move in
opposite directions
DIVERSIFIABLE RISK – the portion of an asset’s
risk that is attributable to firm-specific, random
causes.
NONDIVERSIFIABLE RISK – the relevant portion
of an asset’s risk attributable to market factors that
affect all firms.
PORTFOLIO EFFECTS
• Should the firm maintain a
diversified portfolio of assets?
• Are firms rewarded for
diversifying risk?
• Why are firms not rewarded for
diversification?
RADRs in PRACTICE
• In spite of the appeal of total risk,
RADRs are often used in practice.
Why?
• They are consistent with the general
disposition of financial decision makers
toward rates of return
• They are easily estimated and applied
EXAMPLE
The financial manager of
Bennett Company has assigned
project A to class III and project
B to class II. The cash flows for
project A would be evaluated
using a 14% RADR, and project
B’s would be evaluated using a
10% RADR.
CAPITAL BUDGETING
REFINEMENTS
CAPITAL BUDGETING REFINEMENTS

• Three areas in which special forms

of analysis are frequently needed
are:
• Comparison of mutually exclusive
projects having unequal lives
• Recognition of real options
• Capital rationing caused by a binding
budget constraint
COMPARING PROJECTS WITH UNEQUAL
LIVES

• If the projects are independent,

the length of the project lives is
not critical.
• When unequal-lived projects
are mutually exclusive, the
impact of differing lives must be
considered.
EXAMPLE
The AT Company, a regional cable television
company, is evaluating two projects, X and Y. The
relevant cash flows for each project are given in
the following table. The applicable cost of capital
for use in evaluating these equally risky projects is
10%.
ANNUALIZED NET PRESENT VALUE (ANPV)
• Converts the net present value of unequal-lived,
mutually exclusive projects into an equivalent annual
amount(in NPV terms) that can be used to select the
best project.
• It can be applied by using the following steps:
• Step 1: Calculate the NPV of each project over its life using
the appropriate cost of capital.
• Step 2: Find an annuity that has the same life and same
NPV as the project.
• Step 3: Select the project that has the highest NPV.
STEP 1
• The NPVs of projects X and Y discounted at 10%
are:
STEP 2
• We convert the NPV from step 1 into annuities.
STEP 3
• Reviewing the ANPVs calculated in step 2, we can now
select the project that has the highest ANPV.