EBK CFIN
6th Edition
ISBN: 9781337671743
Author: BESLEY
Publisher: CENGAGE LEARNING - CONSIGNMENT
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Chapter 10, Problem 20PROB
Summary Introduction
Project risk should be considered in the capital budgeting decision. When a project is chosen, it is possible that the risk of the project is different from the firm’s average risk. Hence, it is essential to use the risk adjusted discount rate when evaluating a project. A risk adjusted discount rate is one in which he projects’ risk or the premium of taking the risk of that project is adjusted to the firm’s average risk. Average-risk projects are discounted at the average
Firstly, each project is classified in to three categories, high risk, average risk and low risk. Then the average required rate of return of the firm is used as the discount rate for average risk project, reduces the rate of return by 1-3 percent for low risk project and increases the discount rate accordingly for high risk projects. It is important to incorporate project risk in capital budgeting decision, or else one might end up making incorrect decision.
Following are the two mutually exclusive project which the company needs to evaluate. It usually does so by adjusting its average required rate of return, r of 15%. A high-risk project is adjusted for 5% and a low risk project is adjusted for 3%.
| Project | Risk | |
| X | 14.0% | Average |
| Y | 19.0% | High |
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Students have asked these similar questions
Wolff Enterprises must consider one investment project using the capital asset pricing model (CAPM). Relevant information is presented in the following table.
Item
Rate of return
Beta, b
Risk-free asset
9%
0.00
Market portfolio
14%
1.00
Project
1.74
a. Calculate the required rate of return for the project, given its level of nondiversifiable risk.
b. Calculate the risk premium for the project, given its level of nondiverisifiable risk.
Wolff Enterprises must consider several investment projects, A through E, using the capital asset pricing model (CAPM) and its graphical representation, the security market line (SML). Relevant information is presented in the following table
ITEM RATE OF RETURN BETA
Risk-free asset 9% 0.0
Market portfolio 14% 1.0
Project A - 1.5
Project B - 0.75
Project C - 2.00
Project D - 0.0
Project E - -0.50
Calculate (1) the required rate of return and (2) the risk premium for each project, given its level of nondiversifiable risk.
Use your findings in part a to draw the security market line (required rate of return relative to nondiversifiable risk)
Discuss the relative nondiversifiable risk of projects A through E.
Assume that recent economic events have caused investors to become less risk-averse, causing the market return to decline to 12%. Calculate the new required returns fcor assets A through E and draw the new security market line on the same graph you drew for b.
Compare your findings…
A company estimates that its average-risk projects have a WACC of 10%, its below-average risk projects have a WACC of 8%, and its above-average risk projects have a WACC of 12%. Which of the following projects (A, B, and C) should the company accept?
A) Project C, which is of above-average risk and has a return of 11%.
B) All of the projects should be accepted.
C)Project A, which is of average risk and has a return of 9%.
D)None of the projects should be accepted.
E)Project B, which is of below-average risk and has a return of 8.5%.
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