Professional Documents
Culture Documents
Risk and
Refinements in
Capital
Budgeting
Learning Goals
LG1 Understand the importance of recognizing risk in the
analysis of capital budgeting projects.
LG2 Discuss risk and cash inflows, scenario analysis, and
simulation as behavioral approaches for dealing with
risk.
LG3 Review the unique risks that multinational companies
face.
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Focus on Practice
The Monte Carlo Method: The Forecast Is for Less Uncertainty
To combat uncertainty in the decision-making process, some companies use a
Monte Carlo simulation program to model possible outcomes.
A Monte Carlo simulation program randomly generates values for uncertain
variables over and over to simulate a model.
The simulation then requires project practitioners to develop low, high, and
most likely cost estimates along with correlation coefficients.
One of the problems with using a Monte Carlo program is the difficulty of
establishing the correct input ranges for the variables and determining the
correlation coefficients for those variables.
A Monte Carlo simulation program requires the user to first build an Excel
spreadsheet model that captures the input variables for the proposed project.
What issues and what benefits can the user derive from this process?
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International Risk
Considerations
Exchange rate risk is the danger that an unexpected
change in the exchange rate between the dollar and the
currency in which a projects cash flows are denominated
will reduce the market value of that projects cash flow.
In the short term, much of this risk can be hedged by
using financial instruments such as foreign currency
futures and options.
Long-term exchange rate risk can best be minimized by
financing the project in whole or in part in the local
currency.
2012 Pearson Prentice Hall. All rights
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Matter of Fact
A 2001 survey of Chief Financial Officers (CFOs) found
that more than 40% of the CFOs felt that it was important to
adjust an investment projects cash flows or discount rates to
account for foreign exchange risk.
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International Risk
Considerations (cont.)
Political risk is much harder to protect against. Firms that make
investments abroad may find that the host-country government can
limit the firms ability to return profits back home. Governments
can seize the firms assets, or otherwise interfere with a projects
operation.
The difficulties of managing political risk after the fact make it
even more important that managers account for political risks
before making an investment.
They can do so either by adjusting a projects expected cash
inflows to account for the probability of political interference or by
using risk-adjusted discount rates in capital budgeting formulas.
2012 Pearson Prentice Hall. All rights
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International Risk
Considerations (cont.)
Other special issues relevant for international capital
budgeting include:
Taxes
Transfer pricing
Strategic, rather than financial, considerations
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Figure 12.2
CAPM and SML
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Focus on Ethics
Ethics and the Cost of Capital
On April 20, 2010 the Deepwater Horizon, an offshore drilling rig
operated by Transocean Ltd. on behalf of BP, exploded and
eventually sank in the Gulf of Mexico, killing 11 people.
To make matters worse, oil began spewing into the Gulf.
By June 2010, BPs stock price was 50% below pre-crisis levels
and the companys bonds traded at levels comparable to junk rated
companies.
Is the ultimate goal of the firm, to maximize the wealth of the
owners for whom the firm is being operated, ethical?
Why might ethical companies benefit from a lower cost of capital
than less ethical companies?
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Project B
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Project X
Project Y
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Step 2
Convert the NPVj into an annuity having life nj. That is,
find an annuity that has the same life and the same NPV
as the project.
Step 3
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Project X
Project Y
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Table 12.4
Major Types of Real Options
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Capital Rationing
Firms often operate under conditions of capital rationing
they have more acceptable independent projects than
they can fund.
In theory, capital rationing should not existfirms should
accept all projects that have positive NPVs.
However, in practice, most firms operate under capital
rationing.
Generally, firms attempt to isolate and select the best
acceptable projects subject to a capital expenditure budget
set by management.
2012 Pearson Prentice Hall. All rights
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Chapter Resources on
MyFinanceLab
Chapter Cases
Group Exercises
Critical Thinking Problems
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Integrative Case:
Lasting Impressions Company
Lasting Impressions (LI) Companys general manager has
proposed the purchase of one of two large, six-color presses
designed for long, high-quality runs. The purchase of a new
press would enable LI to reduce its cost of labor and
therefore the price to the client, putting the firm in a more
competitive position. The key financial characteristics of the
old press and of the two proposed presses are summarized in
what follows.
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f.
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