Naturall

Naturall

In our discussion of capital budgeting thus far, we have assumed that a firm’s investment projects all have the same risk, which implies that the acceptance of any project would not change the firm’s overall risk. In actuality, these assumptions often do not hold: Projects are not equally risky, and the acceptance of a project can increase or decrease the firm’s overall risk. We begin this chapter by relaxing these assumptions and focusing on how managers evaluate the risks of different projects. Naturally, we will use many of the risk concepts developed in Chapter 8.

We continue the Bennett Company example from Chapter 10. The relevant cash flows and NPVs for Bennett Company’s two mutually exclusive projects—A and B—appear in Table 12.1.

In the following three sections, we use the basic risk concepts presented in Chapter 8 to demonstrate behavioral approaches for dealing with risk, international risk considerations, and the use of risk-adjusted discount rates to explicitly recognize risk in the analysis of capital budgeting projects.

 REVIEW QUESTION

12–1Are most mutually exclusive capital budgeting projects equally risky? If you think about a firm as a portfolio of many different kinds of investments, how can the acceptance of a project change a firm’s overall risk?

TABLE 12.1 Relevant Cash Flows and NPVs for Bennett Company’s Projects

  Project A Project B
A. Relevant cash flows    
Initial investment −$42,000 −$45,000
Year Operating cash inflows
1 $14,000 $28,000
2  14,000  12,000
3  14,000  10,000
4  14,000  10,000
5  14,000  10,000
B. Decision technique    
NPV @ 10% cost of capitala $11,071 $10,924