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
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 |
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