P12-20 RISK-ADJUSTED DISCOUNT RATES: BASIC Country Wallpapers is considering investing in one of three mutually exclusive projects, E, F, and G. The firm's cost of capital, r, is 10%, and the risk-free rate, RF, is 2%. The firm has estimated each project's cash flow and each project's beta, as shown in the following table. Excel Initial investment (CF) Year (t) 1 N 3 Beta E Where -$15,000 RF B₂ RADR, = $6,000 6,000 6,000 6,000 1.80 Project () F -$11,000 Cash inflows (CF,) $6,000 4,000 5,000 2,000 1.00 a. Find the NPV of each project, using the firm's cost of capital. Which project is preferred in this situation? -$19,000 b. The firm uses the following equation to determine the risk-adjusted discount rate, RADRj, for each project j: RADR;= Rp + ß₂ × (rm · RF) risk-free rate beta of project, risk-adjusted discount rate for project; expected return on market portfolio Substitute each project's beta into this equation to determine its RADR. T'm $ 4,000 6,000 8,000 12,000 0.60 2% 10% c. Use the RADR for each project to determine its risk-adjusted NPV. Which project is preferable in this situation? d. Compare and discuss your findings in parts a and c. Which project do you recommend that the firm accept?
P12-20 RISK-ADJUSTED DISCOUNT RATES: BASIC Country Wallpapers is considering investing in one of three mutually exclusive projects, E, F, and G. The firm's cost of capital, r, is 10%, and the risk-free rate, RF, is 2%. The firm has estimated each project's cash flow and each project's beta, as shown in the following table. Excel Initial investment (CF) Year (t) 1 N 3 Beta E Where -$15,000 RF B₂ RADR, = $6,000 6,000 6,000 6,000 1.80 Project () F -$11,000 Cash inflows (CF,) $6,000 4,000 5,000 2,000 1.00 a. Find the NPV of each project, using the firm's cost of capital. Which project is preferred in this situation? -$19,000 b. The firm uses the following equation to determine the risk-adjusted discount rate, RADRj, for each project j: RADR;= Rp + ß₂ × (rm · RF) risk-free rate beta of project, risk-adjusted discount rate for project; expected return on market portfolio Substitute each project's beta into this equation to determine its RADR. T'm $ 4,000 6,000 8,000 12,000 0.60 2% 10% c. Use the RADR for each project to determine its risk-adjusted NPV. Which project is preferable in this situation? d. Compare and discuss your findings in parts a and c. Which project do you recommend that the firm accept?
Essentials Of Investments
11th Edition
ISBN:9781260013924
Author:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Publisher:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Chapter1: Investments: Background And Issues
Section: Chapter Questions
Problem 1PS
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Transcribed Image Text:P12-20 RISK-ADJUSTED DISCOUNT RATES: BASIC Country Wallpapers is considering investing in one of three
mutually exclusive projects, E, F, and G. The firm's cost of capital, r, is 10%, and the risk-free rate, RF, is 2%. The
firm has estimated each project's cash flow and each project's beta, as shown in the following table. Excel
Initial investment (CF)
Year (t)
1
2
3
4
Beta
E
Where
-$15,000
$6,000
6,000
6,000
6,000
RF
B;
RADR,
1.80
Project ()
F
-$11,000
Cash inflows (CF,)
$6,000
4,000
5,000
2,000
1.00
G
a. Find the NPV of each project, using the firm's cost of capital. Which project is preferred in this situation?
risk-free rate
beta of project;
T'm
risk-adjusted discount rate for project ;
expected return on market portfolio
Substitute each project's beta into this equation to determine its RADR.
-$19,000
b. The firm uses the following equation to determine the risk-adjusted discount rate, RADRj, for each project j:
RADR, RF + B₂ × (rm RF)
$ 4,000
6,000
8,000
12,000
0.60
2%
10%
c. Use the RADR for each project to determine its risk-adjusted NPV. Which project is preferable in this
situation?
d. Compare and discuss your findings in parts a and c. Which project do you recommend that the firm accept?
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