Principles of Managerial Finance

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