Question

4. Risk analysis in capital budgeting

Projects differ in risk, and risk analysis is a critical component of the capital budgeting process.

Consider the case of United Recycling Inc.:

United Recycling Inc. is one of the largest recyclers of glass and paper products in the United States. The company is looking into expanding into the cardboard recycling business. The company’s CFO has performed a detailed analysis of the proposed expansion.

The company’s CFO hired a third-party consulting firm to estimate the cost per ton of processing the cardboard. The consulting firm’s cost estimate for processing the cardboard was significantly higher than what the CFO had been using in his financial model.

Based on the information given, determine which of the statements is correct.

When the CFO adjusts the cost per ton of processing the cardboard, the project’s NPV will decrease.

When the CFO adjusts the cost per ton of processing the cardboard, the project’s NPV will increase.

Evaluating risk is an important part of the capital budgeting process. Which of the following is measured by the variability of the project’s expected returns?

Market, or beta, risk

Corporate, or within-firm, risk

Stand-alone risk

______________________ is measured by the project’s impact on uncertainty regarding the firm’s future returns.

Answer 1

1.

When the CFO adjusts the cost per ton of processing the cardboard, the project’s NPV will decrease.

2.

Stand-alone risk

3.

Corporate or within-firm risk is measured by the project’s impact on uncertainty regarding the firm’s future returns