Wk-4; Q1: A firm uses a single discount rate to compute the NPV of all its potential capital budgeting projects, even though the projects have a wide range of nondiversifiable risk. The firm then undertakes all those projects that appear to have positive NPVs. Briefly explain why such a firm would tend to become riskier over time.
Let’s start with some definitions and simple examples according to authors, Emery, Finnerty and Stowe: “Time Value of Money: The value that a capital budgeting project will create—its NPV—depends on its cost of capital, its required return” (Chap 8, p. 189). Quick Example of use of NPV: “Suppose our example project has an initial cost of $8,000 and an NPV of $2,000, making up its present value of $10,000. Then the shareholders of this project will be putting up $4,000 and receiving $6,000, because they get the positive NPV. So the shareholders own 60% of the value, even though they will be putting up only 50% of the initial cost ($4,000 of the $8,000). The project is referred to as 40% debt financed and 60% equity financed because those proportions reflect the distribution of the market value of the project among the claimants. Proportions of the initial cost are not relevant because they disregard the project’s NPV’ (Chap. 8, p. 198) Small discussion on Discount Rate: “Other names are the hurdle rate and the appropriate discount rate, or simply the discount rate. Although these terms may be used interchangeably, it is important to remember that the cost of capital reflects the riskiness of the capital budgeting project’s cash flows, not the interest rate on its bonds or the riskiness of the firm’s existing assets” (Chap. 9, pp. 220, 221). In response to the question: As noted, discount rate can be inflation rate, interest rate, or desired/expected/required rate of return. A finance manager when mapping out the finance on a project will decide what rate to be used to discount future cash flows. Or evaluate the cost of financing the...
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