Capital Budgeting: Intro and Projection Risk

Question 1

Capital Budgeting Defined:

Answer 1

Capital Budgeting: The process of measuring, evaluating, and selecting long-term investment opportunities for a firm.

Example investments:

• Selecting new equipment and plants
• Evaluating new projects
• Making advertising campaign decisions
• Similar undertakings

Effective capital budgeting is essential for a firm’s success.

Question 2

Project Risks:

Answer 2

• Inherent in every project considered are elements of risk and reward.
• Risk: the possibility of loss or other unfavorable results that derives from the uncertainty implicit in future outcomes.
• Capital Project Risks include:
  
  • Incomplete or incorrect project analysis
  • Unanticipated actions of customers, suppliers, and competitors
  • Unanticipated changes in laws and regulations
  • Unacticipated macroeconomic changes, including interest rates, inflation rates, tax rates, etc.
• Reducing Risks:
  
  • Certain risks associated with individual projects are mitigated by having a large number of diverse projects (a portfolio of projects) which span multiple periods. The reduced risk that results from a large, diverse portfolio of projects results because:
    
    • With a large number of projects, each individual project accounts for a relatively small percentage of total undertakings, thus any unexpected outcome will have only a small impact on the total firm results.
    • With a large number of diverse projects, the unfavorable outcomes experienced by some projects are more likely to be offset by favorable outcomes experienced by other projects.
  • On the other hand, certain risks are likely to impact most projects in the same manner.
    Example: The risk associated with an increase in interest rates would apply similarly to all long-term projects. An unanticipated increase in interest rates would tend to result in lower returns from all long-term projects. In most cases, risks derived from the macroeconomic environment cannot be reduced by project diversification.

Question 3

Risk Reward Relationship:

Answer 3

Risk Reward Relationship: The greater the perceived risk, the greater the expected reward. Thus, the relationship between risk and reward is positive and can be shown graphically as:

Question 4

Define “risk-free rate of return”.

Answer 4

RFR: The rate of return expected solely for the deferred current consumption that results from making an investment; rate of return expected assuming virtually no risk. In the United States it is measured by the rates paid on United States Treasury obligations.

Question 5

Define “risk premium”.

Answer 5

Risk Premium:

The rate of return expected above the risk-free rate based on the perceived level of risk inherent in an investment/undertaking. The Award.

Question 6

Describe the relationship between a firm’s capital projects and the firm’s capital that funds those projects.

Answer 6

The rate of return earned on a firm’s capital project must be equal or greater than the rate of return required to attract and maintain investors’ capital.

Question 7

True or False:

An entity is the sum of total projects undertaken by the firm

Answer 7

TRUE

Question 8

Discount/Hurdle Rate:

Answer 8

Discount/Hurdle Rate: While the cost of capital can be determined for each element of capital (e.g., long-term notes, bonds, preferred stock, common stock, etc.), it is usually appropriate to calculate and use the weighted average cost of capital.

• Specifically, the cost of capital for each element is weighted by the proportion of total capital provided by each element.
• The resulting weighted average is the rate of return that a firm must expect to earn on a project it undertakes.
• In evaluating projects, that rate is called the hurdle rate or discount rate.

Question 9

Question:

As the perceived risk of an undertaking increases, what would be the expected effect on the risk-free rate of return and the risk premium rate of return?

Risk-Free Rate Risk Premium

• Increase Increase
• No change Increase
• No change No change
• Decrease Decrease

Answer 9

Risk-Free Rate Risk Premium

No change Increase

The risk-free rate is the reward expected for deferring current consumption and does not change as the perceived risk of an undertaking increases (or decreases). Therefore, no change would be expected in the risk-free rate. An increase in the risk premium would be expected as a result of an increase in perceived risk; it is the “reward” for risk. Thus, the greater the risk, the greater the expected reward (or risk premium).

Question 10

Question:

The presence of risk for a portfolio of projects means:

A. More than one outcome is possible for any project.
B. Some project will lose money.
C. Changes in tax rates are expected to affect all projects.
D. An inadequate number of projects is being undertaken to fully eliminate all risk.

Answer 10

A. More than one outcome is possible for any project.

Risk is the possibility of loss or other unfavorable result that derives from the uncertainty implicit in future outcomes. In the context of a portfolio of projects, it is the uncertain outcome associated with any project.