Potential Investment Project 3 The third investment that Indian River’s management team asked Constand Consulting to analyze and discuss involves choosing between two different projects, W and C, which are systems of disposing of wastes associated with another product, frozen grape juice. Both systems have an estimated three-year useful life; the project selected will probably be repeated at the end of its life into the foreseeable future. Since the waste disposal projects have no impact on revenues, Indian River’s management team has asked that the relevant cost of the two systems be analyzed. Attachment 10 (page XXX) shows the expected net costs and other supporting information for the two projects. Project W requires more workers
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NPV can be calculated, but is only relevant when both projects have the same WACC value. The larger the WACC value used (when all cash flows are negative), the less negative a project’s NPV becomes (which is wrong).
(C) Risk Analysis in Capital Budgeting Risk is an important consideration in the capital budgeting process. Firms should be concerned with an individual project’s risk because the acceptance of a project can affect the overall riskiness of a firm. An overly-risky project can potentially cause investors to assign a higher discount rate on the firm, which would lead to a lower stock price. The managers of a firm should attempt to do everything that they can to maximize shareholder wealth; this means selecting projects that the firm’s investors are comfortable with. Furthermore, risk can cause a project’s cost of capital to become higher than anticipated. Creditors would assess the riskiness of the project and demand an interest rate that adequately compensates them for lending funds. A higher-than-anticipated cost of capital could make a profitable-looking investment not so attractive to the firm. A firm would want to ensure that the project generated adequate cash flows and that a project was worth taking …show more content…
375). Stand-alone risk is often the most analyzed risk in the capital budgeting process. Brigham and Houston (2009) state that stand-alone risk is “the risk an asset would have if it was a firm’s only asset and investors owned only one stock. It is measured by the variability of the asset’s expected returns” (p. 375). Diversification is totally ignored when analyzing stand-alone risk. Corporate, or within-firm risk, is a project’s risk to the corporation (as opposed to the investor). Brigham and Houston (2009) note that “within-firm risk takes account of the fact that the project is only one asset in the firm’s portfolio of assets; hence, some of its risk will be eliminated by diversification within the firm” (p. 375). Corporate risk is measured by analyzing the project’s impact on uncertainty about the firm’s future
NPV can be calculated, but is only relevant when both projects have the same WACC value. The larger the WACC value used (when all cash flows are negative), the less negative a project’s NPV becomes (which is wrong).
(C) Risk Analysis in Capital Budgeting Risk is an important consideration in the capital budgeting process. Firms should be concerned with an individual project’s risk because the acceptance of a project can affect the overall riskiness of a firm. An overly-risky project can potentially cause investors to assign a higher discount rate on the firm, which would lead to a lower stock price. The managers of a firm should attempt to do everything that they can to maximize shareholder wealth; this means selecting projects that the firm’s investors are comfortable with. Furthermore, risk can cause a project’s cost of capital to become higher than anticipated. Creditors would assess the riskiness of the project and demand an interest rate that adequately compensates them for lending funds. A higher-than-anticipated cost of capital could make a profitable-looking investment not so attractive to the firm. A firm would want to ensure that the project generated adequate cash flows and that a project was worth taking …show more content…
375). Stand-alone risk is often the most analyzed risk in the capital budgeting process. Brigham and Houston (2009) state that stand-alone risk is “the risk an asset would have if it was a firm’s only asset and investors owned only one stock. It is measured by the variability of the asset’s expected returns” (p. 375). Diversification is totally ignored when analyzing stand-alone risk. Corporate, or within-firm risk, is a project’s risk to the corporation (as opposed to the investor). Brigham and Houston (2009) note that “within-firm risk takes account of the fact that the project is only one asset in the firm’s portfolio of assets; hence, some of its risk will be eliminated by diversification within the firm” (p. 375). Corporate risk is measured by analyzing the project’s impact on uncertainty about the firm’s future