Question

Capital Budgeting Decisions A college intem working at Anderson Paints evaluated potential investments using the firm's average required rate of return (n) as the discount role in the evaluation process and he produced the following report for you as the capital budgeting manager at Anderson Paints Project NPV IRR Risk LOM $1.500 12.5% High 11.0 Low (800) 10.0 Average DOG (150) 9.5 Low QUE YUP As the capital investment manager you must account for the risks associated with capital budgeting projects before making final recommendations and decisions. The company's capital investment risk management policy calls for an adjustment of the firm's average required rate of return by plus/minus 2% if a project's risk deviates from the firm's average risk elassification. The table above shows the estimated profitability of each project using the average required rate of return of the company and disregarding any deviation of each project's risk from the firm's average, Your job as the capital investment manager is to account for differences in risk in each project according to company's policy and to make recommendations regarding the acceptability or non-acceptability of each potential investment as part of the upcoming proposed firm's capital budget. First, explain how you would adjust cach project's required rate of return for risk using the risk management policy of the company and discuss the appropriateness of the firm's risk management policy. Second, insert a column in the table above showing the appropriate risk-adjusted required rate of retum or discount rate for each project. Third, explain which of the projects listed above you would recommend and why for the upcoming firm's capital investment budget. ter spot An intro to Capita l Chapter 9 Capitalopte 55683 TON 100g 0,1 g

Answer 1

Net present value is the difference between the present value of all cash inflows and the present value of cash outflows.

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IRR is the internal rate of return at which the project’s NPV is zero.

The investor who accepts the high risk is known as risk seeking investor and the investor who is not willing to accept the risk is known as risk averse investor.

1.

An investor in generally expects more return in the investment made. Therefore, the investor should be ready to take more risk on the investment. This is known as risk-return tradeoff. The risk should be taken into consideration while estimating return, as there are contingencies in the market conditions and the inflation rate fluctuations.

Based on the above calculations of NPV and IRR, the project LOM has higher NPV. As per the NPV decision rule, the project with positive NPV should be accepted and the negative NPV should be rejected.

If the NPV is high, the risk that is associated with the project is also high. If the investor is risk seeker, the project with high NPV and high risk can be accepted. If the investor is risk averse, the it should not be taken into consideration.

2.

The formula for risk adjusted discount rate is as follows:

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From the above table, the project LOM is high risky as the risk-adjusted discount rate is high compared to the other projects.

3. For the upcoming capital budgeting investment, the project LOM is preferable as the NPV is positive. The investor should accept the project only if he is willing to accept the risk.

If the investor is risk averse, then can opt for less risky projects.

Hence, project LOM is preferable.