Principles of Managerial Finance

CHAPTER 10 Risk and Refinements in Capital Budgeting 457

All the firm’s cash inflows have already been adjusted for taxes.

a. Evaluate the projects using risk-adjusted discount rates.

b. Discuss your findings in part a,and recommend the preferred project.

10–9 Risk-adjusted rates of return using CAPM Centennial Catering, Inc., is consid-

ering two mutually exclusive investments. The company wishes to use a risk-

adjusted rate of return in its analysis. Centennial’s cost of capital (similar to the

market return in CAPM) is 12%, and the current risk-free rate of return is 7%.

Cash flows associated with the two projects are as follows:

a. Use a risk-adjusted rate of return approach to calculate the net present

value of each project, given that Project X has a RADR factor of 1.20 and

Project Y has a RADR factor of 1.40. The RADR factors are similar to

project betas. (Use Equation 10.5 to calculate the required project return

for each.)

b. Discuss your findings in part a,and recommend the preferred project.

10–10 Risk classes and RADR Moses Manufacturing is attempting to select the best

of three mutually exclusive projects, X, Y, and Z. Though all the projects have

5-year lives, they possess differing degrees of risk. Project X is in class V, the

highest-risk class; project Y is in class II, the below-average-risk class; and proj-

ect Z is in class III, the average-risk class. The basic cash flow data for each

project and the risk classes and risk-adjusted discount rates (RADRs) used by the

firm are shown in the following tables.

Project X Project Y Project Z

Initial investment (CF 0 ) $180,000 $235,000 $310,000

Year (t) Cash inflows (CFt)

1 $80,000 $50,000 $90,000

2 70,000 60,000 90,000

3 60,000 70,000 90,000

4 60,000 80,000 90,000

5 60,000 90,000 90,000

Project X Project Y

Initial investment (CF 0 ) $70,000 $78,000

Year (t) Cash inflows (CFt)

1 $30,000 $22,000

2 30,000 32,000

3 30,000 38,000

4 30,000 46,000

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