November 26, 2014

Chapter 12. Capital Budgeting and Risk Analysis of Projects

. Risk analysis in capital budgeting

 Adjusting the cost of capital for risk

 Project stand-alone risk: the risk of a project as if it were the firm’s only project

 Project’s within-firm risk: the amount of risk that a project contributes to the firm

Project’s market risk: the risk that a project contributes to the market, measured
by the project’s beta coefficient

 Pure play method to estimate a new project’s market risk

Identify firms producing only one product that is the same as your project is going
to produce and estimate betas for these firms; average these betas to proxy for
your project’s beta: use CAPM to estimate your project’s required rate of return

Methods to incorporate risk into capital budgeting

Risk-adjusted cost of capital: use the beta risk to estimate the required rate of  return for the project and use that rate as the discount rate to evaluate the project; the higher the risk, the higher the discount rate

. Optimal capital budget

 The annual investment in long-term assets that maximizes the firm’s value

 Capital rationing: the situation in which a firm can raise a specified, limited amount of capital regardless of how many good projects it has

 For example, a firm has $5 million of capital budget and has three good projects


Initial investment











 The firm should choose projects B and C to maximize firm’s value

MBA Core Management Knowledge - One Year Revision Schedule


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