426 PART 3 Long-Term Investment Decisions
10.1 Introduction to Risk in Capital Budgeting
The capital budgeting techniques introduced in Chapter 9 were applied in an
environment we assumed to be certain. All of the projects’ relevant cash flows,
developed using techniques presented in Chapter 8, were assumed to have the
same level of risk as the firm. In other words, all mutually exclusive projects were
equally risky, and the acceptance of any project would not change the firm’s over-
all risk. In actuality, these situations are rare—project cash flows typically have
different levels of risk, and the acceptance of a project generally does affect the
firm’s overall risk, though often in a minor way. We begin this chapter by relax-
ing the assumptions of a certain environment and equal-risk projects, in order to
focus on the incorporation of risk into the capital budgeting decision process.
For convenience, in this chapter, we continue the Bennett Company example
that was used in Chapter 9. The relevant cash flows and NPVs for Bennett Com-
pany’s two mutually exclusive projects—A and B—are summarized in Table 10.1.
In the following three sections, we use the basic risk concepts presented in
Chapter 5 to demonstrate behavioral approaches for dealing with risk, interna-
tional risk considerations, and the use of risk-adjusted discount rates to explicitly
recognize risk in the analysis of capital budgeting projects.Review Question
10–1 Are most mutually exclusive capital budgeting projects equally risky?
How can the acceptance of a project change a firm’s overall risk?TABLE 10.1 Relevant Cash Flows and
NPVs for Bennett
Company’s ProjectsProject A Project BA. Relevant Cash FlowsInitial Investment $42,000 $45,000
Year Operating cash inflows1 $14,000 $28,000
2 14,000 12,000
3 14,000 10,000
4 14,000 10,000
5 14,000 10,000B. Decision TechniqueNPV @ 10% cost of capitala $11,071 $10,924
aFrom Figure 9.2 on page 402; calculated using a financial calculator.LG1