CHAPTER NINE C A P I T A L B U D G E T I N G A N D R I S K The development of modern theories linking risk and expected return, smart financial managers adjusted for risk in capital budgeting. They realized intuitively that, other things being equal, risky projects are less desirable than safe ones. | Brealey-Meyers Principles of Corporate Finance Seventh Edition II. Risk 9. Capital Budgeting and The McGraw-Hill Companies 2003 Risk Brealey-Meyers Principles of Corporate Finance Seventh Edition II. Risk 9. Capital Budgeting and Risk The McGraw-Hill Companies 2003 LONG BEFORE THE development of modern theories linking risk and expected return smart financial managers adjusted for risk in capital budgeting. They realized intuitively that other things being equal risky projects are less desirable than safe ones. Therefore financial managers demanded a higher rate of return from risky projects or they based their decisions on conservative estimates of the cash flows. Various rules of thumb are often used to make these risk adjustments. For example many companies estimate the rate of return required by investors in their securities and then use this company cost of capital to discount the cash flows on new projects. Our first task in this chapter is to explain when the company cost of capital can and cannot be used to discount a project s cash flows. We shall see that it is the right hurdle rate for those projects that have the same risk as the firm s existing business however if a project is more risky than the firm as a whole the cost of capital needs to be adjusted upward and the project s cash flows discounted at this higher rate. Conversely a lower discount rate is needed for projects that are safer than the firm as a whole. The capital asset pricing model is widely used to estimate the return that investors It states Expected return r rf beta rm rf We used this formula in the last chapter to figure out the return that investors expected from a sample of common stocks but we did not explain how to estimate beta. It turns out that we can gain some insight into beta by looking at how the stock price has responded in the past to market fluctuations. Beta is difficult to measure accurately for an individual firm Greater accuracy can be achieved by looking .
