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 rate of return of the project, whereas high risk projects are discounted at higher than average rate of return and lower risk project is discounted at lower than average rate of return.

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	IRR	Risk
X	14.0%	Average
Y	19.0%	High