. 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
Project
Initial investment
NPV
A
$5,000,000
$1,000,000
B
$3,000,000
$600,000
C
$2,000,000
$500,000
The firm should choose projects B and C to maximize firm’s value
MBA Core Management Knowledge - One Year Revision Schedule
.
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
Project
Initial investment
NPV
A
$5,000,000
$1,000,000
B
$3,000,000
$600,000
C
$2,000,000
$500,000
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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