CFIN -STUDENT EDITION-ACCESS >CUSTOM<
6th Edition
ISBN: 9780357752951
Author: BESLEY
Publisher: CENGAGE C
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Chapter 10, Problem 19PROB
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 three independent project which the company needs to evaluate. It usually does so by adjusting its average required rate of return, r of 11%. A high-risk project is adjusted for 4% and a low risk project is adjusted for 2%.
| Project | Risk | |
| P | 10.0% | Low |
| Q | 12.0% | Average |
| R | 14.5% | High |
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Write in memo format a response to your Manager, based on the information presented below for the Duncan Company and also based on your additional research. Your Manager has advised you to make any assumptions where necessary.
Duncan Company is a large manufacturer and distributor of cake supplies. It is based in United Kingdon (Headquarters) It sends supplies to firms throughout the United States and the Caribbean . It markets its supplies through periodic mass mailings of catalogues to those firms. Its clients can make orders over the phone and Duncan ships the supplies upon demand. The main competition for Duncan’s comes from one U.S. firm and one Canadian firm. Another British firm has a small share of the U.S. market but is at a disadvantage because of its distance. The British firm’s marketing and transportation costs in the U.S. market are relatively high. a) Duncan Company plans to penetrate either the Canadian market or two other Caribbean Countries (Jamaica and Haiti). What…
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