Principles of Managerial Finance, 15e (Zutter)
Chapter 12 Risk and Refinements in Capital Budgeting
12.1 Introduction to risk in capital budgeting
1) Different projects have different levels of risk. As a result, the acceptance of a particular project
generally has an impact on a firm’s overall risk.
2) The acceptance of a particular project usually has no impact on a firm’s overall risk.
3) All projects should always use the WACC as the required return for capital budgeting purposes.
1) Behavioral approaches for dealing with risk include scenario analysis and simulation.
2) Behavioral approaches for dealing with risk include annualized net present values and risk-adjusted
discount rates.
3) In capital budgeting, risk refers to the uncertainty surrounding the cash flows that a project will
generate and the degree of variability of project cash flows.
4) In capital budgeting, risk is generally thought of as the chance that NPV and IRR will provide
conflicting recommendations to management.
5) The break even cash inflow is the minimum level of cash inflow necessary for a project to be
acceptable.
6) Projects with a small chance of being acceptable and a broad range of possible cash flows are riskier
than projects having a high chance of being acceptable and a narrow range of possible cash flows.
7) In capital budgeting, risk refers to a high degree of variability of the initial investment of a project.
8) In capital budgeting, one of the most common scenario approaches is to estimate the NPVs associated
with pessimistic (worst), most likely (expected), and optimistic (best) estimates of cash inflow.
9) Scenario analysis is a behavioral approach that evaluates the impact on a firm’s return through
simultaneous changes in a number of variables.
10) Scenario analysis is a behavioral approach that uses a number of possible outcomes to asses the
variability of returns.
11) Simulation is a statistics-based approach used in capital budgeting to get a feel for risk by applying
predetermined probability distributions and random numbers to estimate risky outcomes.
12) The output of simulation provides an excellent basis for decision making since it allows the decision
maker to view a continuum of risk-return trade-offs rather than a single-point estimate.
13) Monte Carlo simulation programs usually build a histogram of the results.
14) Behavioral approaches ________.
A) are used to explicitly recognize project risk
B) are used to get a feel for project risk
C) are not used by rational financial managers
D) are used to quantify the risk
15) Breakeven cash inflow refers to ________.
A) the minimum level of cash inflow necessary for a project to be acceptable, that is, NPV greater than or
equal to zero
B) the minimum level of cash inflow necessary for a project to be acceptable, that is, NPV less than zero
C) the minimum level of cash inflow necessary for a project to be acceptable, that is, IRR less than zero
cost of capital
D) the minimum level of cash inflow necessary for a project to be acceptable, that is, IRR equals zero
16) In capital budgeting, risk refers to ________.
A) the chance that a project will prove acceptable
B) the conflicting IRR and NPV in a project
C) the degree of variability of initial outlay
D) the uncertainty of cash flows
17) In capital budgeting, risk refers to ________.
A) the degree of variability of the cash flows
B) the degree of variability of the initial investment
C) the chance that the net present value will be greater than zero
D) the chance that the internal rate of return will exceed the cost of capital
18) Tangshan Mining Company, with a cost of capital of 10 percent, is considering investing in project A,
with an initial investment of $1,000,000. Project A is expected to provide equal cash inflows over its 15
year useful life. Based on this information, the breakeven cash inflow for the project is ________.
A) $1,000,000
B) $131,474
C) $100,000
D) $66,667
Table 12.1
A corporation is assessing the risk of two capital budgeting proposals. The financial analysts have
developed pessimistic, most likely, and optimistic estimates of the annual cash inflows which are given in
the following table. The firm’s cost of capital is 10 percent.
19) The range of the annual cash inflows for Project A is ________. (See Table 12.1)
A) $30,000
B) $10,000
C) $5,000
D) $0
20) If the projects have five-year lives, the range of the net present value for Project B is approximately
________. (See Table 12.1)
A) $80,563
B) $201,000
C) $255,444
D) $303,263
21) The expected net present value of Project A if the outcomes are equally probable and the project has
five-year life is ________. (See Table 12.1)
A) -$1,045
B) $17,910
C) $36,865
D) $93,730
22) A behavioral approach that evaluates the impact on a firm’s return through simultaneous changes in a
number variables of a project is called ________.
A) sensitivity analysis
B) scenario analysis
C) simulation analysis
D) Monte Carlo simulation
23) The advantage of using simulation in the capital budgeting process is the ________.
A) ease of calculation over scenario analysis
B) continuum of risk-return trade-offs for decision making
C) single point estimate that helps the decision maker to choose the most accurate alternative
D) use of several possible outcomes to asses risk
24) One type of simulation program made popular by the widespread use of personal computers is called
________.
A) Monaco Simulation
B) Lemans Simulation
C) Cannes Simulation
D) Monte Carlo Simulation
12.3 International risk considerations
1) In international trade, transfer prices are prices that subsidiaries charge each other for the goods and
services traded between them.
2) The danger that an unexpected change in the exchange rate between the dollar and the currency in
which a project’s cash flows are denominated will reduce the market value of that project’s cash flow is
called exchange rate risk.
3) International capital budgeting differs from domestic capital budgeting as cash inflows and outflows
occur in a foreign currency and foreign investments potentially face significant political risk.
4) In case of international capital budgeting, long-term exchange rate risk can be minimized by financing
the project, in whole or in part, in local currency.
5) The importance and widespread use of transfer pricing in international trade makes capital budgeting
in MNCs very difficult unless the transfer prices that are used accurately reflect actual costs and
incremental cash flows.
6) The two basic types of risk associated with international cash flows are foreign exchange risks and
political risks.
7) Exchange rate risk is the risk that an unexpected change in exchange rates will reduce the market value
of a project’s cash flows.
8) Exchange rate risk is easier to protect as compared to political risk.
9) Political risk is easier to protect as compared to exchange rate risk.
10) Which of the following is an important type of risk in an international capital budgeting context?
A) business cycle risk
B) political risk
C) appropriation risk
D) default risk
12.4 Risk-adjusted discount rates
1) The risk-adjusted discount rate (RADR) is the risk-adjustment factor that represents the percent of
estimated cash inflows that investors would be satisfied to receive for certain rather than the cash inflows
that are possible for each year.
2) The risk-adjusted discount rate (RADR) is the rate of return that must be earned on a given project to
compensate a firm’s owners adequately, that is, to maintain or improve the firm’s share price.
3) The security market line can be used as a graphical presentation of the appropriate discount rate
associated with each level of project risk.
4) In CAPM, the total risk is defined as the sum of nondiversifiable and diversifiable risk.
5) Because of the basic mathematics of compounding and discounting, the risk-adjusted discount rate
(RADR) approach implicitly assumes that risk is an increasing function of time.
6) The higher the risk of a project, the higher its risk-adjusted discount rate and thus the lower the net
present value for a given stream of cash inflows.
7) For assets traded in an efficient market, the diversifiable risk can be eliminated through diversification.
8) The risk-adjusted discount rate can be computed as the risk free rate plus the product of a project’s beta
and the market risk premium.
9) The risk-adjusted discount rate can be computed as the risk free rate plus the product of a project’s beta
and the credit risk premium.
10) In applying risk-adjusted discount rates to project selection, projects falling above the SML would
have a positive NPV and those falling below the SML would have a negative NPV.
11) In applying risk-adjusted discount rates to project selection, projects falling above the SML would
have a negative NPV and those falling below the SML would have a positive NPV.
12) The higher the risk-adjusted net present, the more viable the project.
13) Because a business firm can be viewed as a portfolio of assets, it is important that the firm maintains a
diversified portfolio of assets.
14) Even though a business firm can be viewed as a portfolio of assets, firms are not rewarded for
selecting a diversified portfolio of assets because investors can more efficiently diversify the risk on their
own.
15) RADRs are popular because they are consistent with the general disposition of financial decision
makers toward rates of return.
16) ________ reflects the return that must be earned on the given project to compensate the firm’s owners
adequately.
A) Internal rate of return
B) Cost of capital
C) Risk-adjusted discount rate
D) Average rate of return
17) The difference by which the required discount rate exceeds the risk-free rate is called the ________.
A) excess return
B) risk premium
C) inflation premium
D) maturity premium
18) A preferred approach for risk adjustment of capital budgeting cash flows, from a practical viewpoint,
is ________.
A) sensitivity analysis
B) simulation analysis
C) scenario analysis
D) risk-adjusted discount rates
19) The theoretical basis from which the concept of risk-adjusted discount rates is derived is ________.
A) the Gordon model
B) the capital asset pricing model
C) simulation theory
D) the basic cost of money
Table 12.2
A firm is considering investment in a capital project which is described below. The firm’s cost of capital is
18 percent and the risk-free rate is 6 percent. The project has a risk index of 1.5. The firm uses the
following equation to determine the risk adjusted discount rate, RADR, for each project: RADR = Rf +
Risk Index (Cost of capital – Rf)
20) The net present value without adjusting the discount rate for risk is ________. (See Table 12.2)
A) $336,000
B) $250,000
C) $179,400
D) $87,000
21) The discount rate that should be used in the net present value calculation to compensate for risk is
________. (See Table 12.2)
A) 6 percent
B) 15 percent
C) 18 percent
D) 24 percent
22) The net present value of the project when adjusting for risk is ________. (See Table 12.2)
A) -$9,300
B) $0
C) $87,000
D) $105,000
Table 12.3
Tangshan Mining Company is considering investment in one of two mutually exclusive projects M and N
which are described below. Tangshan Mining’s overall cost of capital is 15 percent, the market return is 15
percent and the risk-free rate is 5 percent. Tangshan estimates that the beta for project M is 1.20 and the
beta for project N is 1.40.
23) Using the risk-adjusted discount rate method of project evaluation, the NPV for Project M is ________.
(See Table 12.3)
A) $156,494
B) $122,970
C) $85,732
D) $500,000
24) Using the risk-adjusted discount rate method of project evaluation, the NPV for Project N is ________.
(See Table 12.3)
A) $166,132
B) $122,970
C) $85,732
D) $600,000