Principles of Managerial Finance

(Dana P.) #1

438 PART 3 Long-Term Investment Decisions


Spreadsheet Use Analysis of projects using risk-adjusted discount rates
(RADRs) also can be calculated as shown on the following Excel spreadsheet.

The usefulness of risk-adjusted discount rates should now be clear. The real
difficulty lies in estimating project risk and linking it to the required return
(RADR).

Portfolio Effects
As noted in Chapter 5, because investors are not rewarded for taking diversifiable
risk, they should hold a diversified portfolio of securities. Because a business firm
can be viewed as a portfolio of assets, is it similarly important that the firm main-
tain a diversified portfolio of assets?
It seems logical that by holding a diversified portfolio the firm could reduce
the variability of its cash flows. By combining two projects with negatively corre-
lated cash inflows, the firm could reduce the combined cash inflow variability—
and therefore the risk.
Are firms rewarded for diversifying risk in this fashion? If they are, the value
of the firm could be enhanced through diversification into other lines of business.
Surprisingly, the value of the stock of firms whose shares are traded publicly in an
efficient marketplace is generallynotaffected by diversification. In other words,
diversification is not normally rewarded and therefore is generally not necessary.
Why are firms not rewarded for diversification? Because investors themselves
can diversify by holding securities in a variety of firms; they do not need the firm
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