LEARNING GOALS

424

RISK AND REFINEMENTS

IN CAPITAL BUDGETING

CHAPTER

Across the Disciplines WHY THIS CHAPTER MATTERS TO YOU

Accounting:You need to understand the risk caused by the
variability of cash flows, how to compare projects with unequal
lives, and how to measure project returns when capital must be
rationed.

Information systems:You need to understand how risk is
incorporated into capital budgeting techniques, and how those
techniques may be refined in the face of special circum-
stances, in order to design decision modules that help analyze
proposed capital projects.

Management:You need to understand behavioral approaches
for dealing with risk, including international risk, in capital bud-
geting decisions; how to refine capital budgeting techniques
when projects have unequal lives or when capital must be

rationed; and how to recognize real options embedded in capi-

tal projects.

Marketing:You need to understand how the risk of proposed

projects is measured in capital budgeting, how mutually exclu-

sive projects with unequal lives will be evaluated, what real

options may be embedded in proposed projects and how those

options may affect project implementation, and how projects

will be evaluated when capital must be rationed.

Operations:You need to understand how proposals for the

acquisition of new equipment and plants will be evaluated by

the firm’s decision makers, especially projects that are risky,

have unequal lives, or may need to be abandoned or slowed, or

when capital is limited.

Recognize the problem caused by unequal-lived

mutually exclusive projects and the use of

annualized net present values (ANPVs) to

resolve it.

Explain the role of real options and the objective

of, and basic approaches to, project selection

under capital rationing.

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Understand the importance of explicitly recog- LG5

nizing risk in the analysis of capital budgeting

projects.

Discuss breakeven cash inflow, sensitivity and

scenario analysis, and simulation as behavioral

approaches for dealing with risk.

Discuss the unique risks that multinational com-

panies face.

Describe the determination and use of risk-

adjusted discount rates (RADRs), portfolio effects,

and the practical aspects of RADRs.

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