Saturday, February 03, 2007

Managerial finance -- Chapter 10 -- summary

Not all capital budgeting projects have the same level of risk as the firm's existing portfolio of projects. In addition, mutually exclusive projects often possess differing levels of risk. The financial manager must therefore adjust projects for differences in risk when evaluating their except ability. With Al such adjustment, management could mistakenly accept projects that destroy shareholder value or could reject projects that create shareholder value. To ensure that neither of these outcomes occurs, the financial manager must make sure that only those projects that create shareholder value are recommended.

Risk adjusted discount rates (RADRs) provide a mechanism for adjusting the discount rate said that it is consistent with the risk-return preferences of market participants and thereby with excepting only value creating projects. Procedures for comparing projects with unequal lives, procedures for explicitly recognizing real options embedded in capital projects, and procedures for selecting projects under capital rationing and able the financial manager to refine the capital budgeting process farther. These procedures, along with risk adjustment techniques, should enable the financial manager to make capital budgeting decisions that are consistent with the firm's goal of maximizing stock price.

Recognizing risk
the cash flows associated with capital budgeting projects typically have different levels of risk, and the acceptance of a project generally affects the firms overall risk. Thus it is important to incorporate risk considerations in capital budgeting. Various behavioral approaches can be used to get a feel for the level of the project risk, whereas other approaches explicitly recognize project risk in the analysis of capital budgeting projects.

Risk in capital budgeting is the degree of variability of cash flows. Finding the breakeven cash inflow and estimating the probability that it will be realized make up one behavioral approach for assessing capital budgeting risk. Sensitivity analysis and scenario analysis are also behavioral approaches for capturing the variability of cash inflows and NPVs. Simulation is a statistically based approach that results in a probability distribution of Project returns.

Unique risks
although the basic capital budgeting techniques are the same for multinational and purely domestic companies, firms that operate in several countries must also deal with exchange-rate and political risks, tax law differences, transfer pricing, and strategic issues.

RADRs
the risk of a project whose initial investment is known with certainty is embodied in the present value of its cash inflows, using NPV. Two opportunities to adjust the present value of cash inflows for risk exist -- adjust the cash inflows or adjust the discount rate. Because adjusting the cash inflows is highly subjective, adjusting discount rates is more popular. The RADRs use a market-based adjustment of the discount rate to calculate NPV. The RADR is closely linked to CAPM, but because real corporate assets are generally not traded in an efficient market, the CAPM cannot be applied directly to capital budgeting. Instead, firms develop some CAPM- type relationship to leak a projects risk to its required return, which is used as the discount rate. Often, for convenience, firms will rely on total risk as an approximation for relevant risk when estimating require Project returns. RADRs are commonly used in practice, because decision-makers prefer rates of return and find an easy to estimate and apply.

ANPVs
the ANPV approach is the most efficient method of comparing ongoing, mutually exclusive projects that have unequal usable lives. It converts the NPV of each unequal lived project into an equivalent annual amount -- it's ANPV. The ANPV can be calculated using financial tables, a financial calculator, or a spreadsheet. The project with the highest ANVP is best.

Real options
Real options are opportunities that are embedded in capital projects that allow managers to alter their cash flow and risk in a way that affects project except ability (NPV). By explicitly recognizing real options, the financial manager can find a project strategic NPV. Some of the more common types of real options are abandonment, flexibility, growth, and timing options. The strategic NPV improves the quality of the capital budgeting decision.

Capital rationing exists when firms have more acceptable independent projects and they can fund. Although, in theory, capital rationing should not exist, in practice it commonly occurs. Its objective is to select from all acceptable projects the group that provides the highest overall net present value and does not require more dollars than our budget. The two basic approaches for choosing projects under capital rationing are the internal rate of return approach and the net present value approach. The NPV approach better achieve the objective of using the budget to generate the highest present value of inflows.