Principles of Managerial Finance

CHAPTER 10 Risk and Refinements in Capital Budgeting 441

renewal activities; higher-risk projects involve expansion, often into new or unfa-

miliar activities.

The financial manager of Bennett has assigned project A to class III and proj-

ect B to class II. The cash flows for project A would be evaluated using a 14%

RADR, and project B’s would be evaluated using a 10% RADR.^6 The NPV of

project A at 14% was calculated in Figure 10.3 to be $6,063, and the NPV for

project B at a 10% RADR was shown in Table 10.1 to be $10,924. Clearly, with

RADRs based on the use of risk classes, project B is preferred over project A. As

noted earlier, this result is contrary to the preferences shown in Table 10.1, where

differing risks of projects A and B were not taken into account.

Review Questions

10–5 Describe the basic procedures involved in using risk-adjusted discount

rates (RADRs).How is this approach related to the capital asset pricing

model (CAPM)?

10–6 Explain why a firm whose stock is actively traded in the securities markets

need not concern itself with diversification. In spite of this, how is the risk

of capital budgeting projects frequently measured? Why?

10–7 How are risk classes often used to apply RADRs?

10.5 Capital Budgeting Refinements

Refinements must often be made in the analysis of capital budgeting projects to

accommodate special circumstances. These adjustments permit the relaxation of

certain simplifying assumptions presented earlier. Three areas in which special

forms of analysis are frequently needed are (1) comparison of mutually exclusive

projects having unequal lives, (2) recognition of real options, and (3) capital

rationing caused by a binding budget constraint.

Comparing Projects with Unequal Lives

The financial manager must often select the best of a group of unequal-lived proj-

ects. If the projects are independent, the length of the project lives is not critical.

But when unequal-lived projects are mutually exclusive, the impact of differing

lives must be considered because the projects do not provide service over compa-

rable time periods. This is especially important when continuing service is needed

from the project under consideration. The discussions that follow assume that the

unequal-lived, mutually exclusive projects being compared are ongoing.If they

were not, the project with the highest NPV would be selected.

6. Note that the 10% RADR for project B using the risk classes in Table 10.3 differs from the 11% RADR used
   in the preceding example for project B. This difference is attributable to the less precise nature of the use of risk
   classes.

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