450 PART 3 Long-Term Investment Decisions
B, C, and A is preferable, because they maximize the present value for the given
budget. The firm’s objective is to use its budget to generate the highest present
value of inflows.Assuming that any unused portion of the budget does not gain
or lose money, the total NPV for projects B, C, and E would be $106,000
($336,000$230,000), whereas for projects B, C, and A the total NPV would be
$107,000 ($357,000$250,000). Selection of projects B, C, and A will therefore
maximize NPV.Review Questions
10–8 Explain why a mere comparison of the NPVs of unequal-lived, ongoing,
mutually exclusive projects is inappropriate. Describe the annualized net
present value (ANPV)approach for comparing unequal-lived, mutually
exclusive projects.
10–9 What are real options?What are some major types of real options?
10–10 What is the difference between the strategic NPV and the traditional
NPV?Do they always result in the same accept–reject decisions?
10–11 What is capital rationing?In theory, should capital rationing exist? Why
does it frequently occur in practice?
10–12 Compare and contrast the internal rate of return approachand the net
present value approachto capital rationing. Which is better? Why?SUMMARY
FOCUS ON VALUE
Not all capital budgeting projects have the same level of risk as the firm’s existing portfolio
of projects. In addition, mutually exclusive projects often possess differing levels of risk.
The financial manager must therefore adjust projects for differences in risk when evaluating
their acceptability. Without such adjustment, management could mistakenly accept projects
that destroy shareholder value or could reject projects that create shareholder value. To
ensure that neither of these outcomes occurs, the financial manager must make sure that
only those projects that create shareholder value are recommended.
Risk-adjusted discounts rates (RADRs) provide a mechanism for adjusting the discount
rate so that it is consistent with the risk–return preferences of market participants and
thereby accepting only value-creating projects. Procedures for comparing projects with
unequal lives, procedures for explicitly recognizing real options embedded in capital proj-
ects, and procedures for selecting projects under capital rationing enable the financial man-
ager to refine the capital budgeting process further. These procedures, along with risk-
adjustment techniques, should enable the financial manager to make capital budgeting
decisions that are consistent with the firm’s goal of maximizing stock price.