CFIN -STUDENT EDITION-ACCESS >CUSTOM<
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ISBN: 9780357752951
Author: BESLEY
Publisher: CENGAGE C
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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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Scenario one: Under what circumstances would it be appropriate for a firm to use different cost of capital for its different operating divisions? If the overall firm WACC was used as the hurdle rate for all divisions, would the riskier division or the more conservative divisions tend to get most of the investment projects? Why? If you were to try to estimate the appropriate cost of capital for different divisions, what problems might you encounter? What are two techniques you could use to develop a rough estimate for each division’s cost of capital?
Scenario three: If a portfolio has a positive investment in every asset, can the expected return on a portfolio be greater than that of every asset in the portfolio? Can it be less than that of every asset in the portfolio? If you answer yes to one of both of these questions, explain and give an example for your answer(s).
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