452 PART 3 Long-Term Investment Decisions
SELF-TEST PROBLEM (Solution in Appendix B)
ST 10–1 Risk-adjusted discount rates CBA Company is considering two mutually
exclusive projects, A and B. The following table shows the CAPM-type relation-
ship between a risk index and the required return (RADR) applicable to CBA
Company.
Project data are shown as follows:
a. Ignoring any differences in risk and assuming that the firm’s cost of capital is
10%, calculate the net present value (NPV) of each project.
Project A Project B
Initial investment (CF 0 ) $15,000 $20,000
Project life 3 years 3 years
Annual cash inflow (CF) $7,000 $10,000
Risk index 0.4 1.8
Risk index Required return (RADR)
0.0 7.0% (risk-free rate, RF)
0.2 8.0
0.4 9.0
0.6 10.0
0.8 11.0
1.0 12.0
1.2 13.0
1.4 14.0
1.6 15.0
1.8 16.0
2.0 17.0
flexibility, growth, and timing options. The strate-
gic NPV explicitly recognizes the value of real
options and thereby improves the quality of the cap-
ital budgeting decision.
Capital rationing exists when firms have more
acceptable independent projects than they can fund.
Although, in theory, capital rationing should not
exist, in practice it commonly occurs. Its objective is
to select from all acceptable projects the group that
provides the highest overall net present value and
does not require more dollars than are budgeted.
The two basic approaches for choosing projects un-
der capital rationing are the internal rate of return
approach and the net present value approach. The
NPV approach better achieves the objective of using
the budget to generate the highest present value of
inflows.
LG4