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Review Questions

1. is important in the capital budgeting process.

or terms

2. Risk can be measured in either

3. The use of is based on the concept that investors demand for

riskier projects.

263

CAPITAL BUDGETING UNDER RISK

CHAP. 91

4. The certainty equivalent approach is directly drawn from the concept of

is used as the discount rate under the

5. Under the certainty equivalent approach,

NPV method and as the cutoff rate under the IRR method.

6. Simulation is often called simulation.

7. attempts to determine how sensitive NPV or IRR is to changing conditions.

of possible outcomes.

8. N n ) is a graphical exposition of the

,the expected value and the

9. If the probability distribution is may

be used to compute the probability of a projectâ€™s providing an NPV of less or greater than zero.

plus a

10. The required rate of return on a companyâ€™s security is equal to the

11. Riskier projects should be evaluated with a higher discount rate, called a

12. An easier way to determine beta is to determine the of the least-squares linear

of the security is regressed against the

regression line, where the

of the

13. Relative risk is measured by the

14. is an index of risk.

Answers: (1)Risk analysis; (2) absolute, relative; (3) risk-adjusted rates of return, higher returns; (4)utility theory;

(5) the risk-free rate; (6) Monte Carlo; (7)Sensitivity analysis; (8)decision tree (or probability tree), sequence; (9)

normal, standard deviation; (10) risk-free rate, risk premium; (11) risk-adjusted discount rate; (12) slope, excessive

return, excessive return, market portfolio; (13) coefficient of variation; (14) Beta, systematic (noncontrollable,

nondiversifiable).

Solved Problems

91

. Expected Value and Standard Deviation. The Lendel Company is considering investment in one

of two mutually exclusive projects. They have the following cash inflows for each of the next 3

years:

Cash Inflows ($)

__

˜

Probability Project A Project B

3,000

0.10 3,000

4,000

0.25 3,500

5,000

0.30 4,000

4,500

0.25 6,000

7,000

5,000

0.10

CAPITAL BUDGETING UNDER RISK

264 [CHAP. 9

Calculate ( a ) the expected value (expected cash inflow) of each project; ( b ) the standard

deviation of each project; and (c) the coefficient of variation. ( d ) Which project has the greater

degree of risk? Why?

SOLUTION

n i n

For project A:

-A)â€™P,

A)â€™ ($)

A1 -A ($1

AI ($) pi Alp, ($) (A,- (A,

300 1,000,OOo 100,000

-, O

1O

O

0.10

3,000

875

3,500 0.25 -500 250,000 62,500

0 0 0

1,200

4,000 0.30

0.25 500

4,500 1,125 250,000 62,500

5,000 1,000,OOO 100,000

0.10 ,000

500 1

a2= 325,000

A = 4,000

Since u2= 325,000, a = $570.09.

For project B:

(AI-A)â€™ 6)

Alp, 6) (A, -A)($) (A1-A)â€™Pi ($1

A, ($1 PI

-2,000

300 400,000

4,000,000

0.10

3,000

250,000

1,˜,OOo

0.25 1,000

4,000 -1,000

0 0

1,500 0

0.30

5,000

250,000

0.25 1,000,000

1,500 1,000

6,000

400,000

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