Question
SHOW HOW TO GET EACH PART. P12 20 RISK-ADJUSTED DISCOUNT RATES: BASIC Country Wallpapers is considering investing in one of three mutually exclusive projects, E,
SHOW HOW TO GET EACH PART.
P1220 RISK-ADJUSTED DISCOUNT RATES: BASICCountry Wallpapers is considering investing in one of three mutually exclusive projects, E, F, and G. The firms cost of capital, r, is 10%, and the risk-free rate, RF, is 2%. The firm has estimated each projects cash flow and each projects beta, as shown in the following table.
| Project (j) | |||
| E | F | G | |
| Initial investment (CF0) | -$15,000 | -$11,000 | -$19,000 |
| Year (t) | Cash inflows (CFt) | ||
| 1 | $6,000 | $6,000 | $ 4,000 |
| 2 | 6,000 | 4,000 | 6,000 |
| 3 | 6,000 | 5,000 | 8,000 |
| 4 | 6,000 | 2,000 | 12,000 |
| Beta | 1.80 | 1.00 | 0.60 |
- Find the NPV of each project, using the firms cost of capital. Which project is preferred in this situation?
- The firm uses the following equation to determine the risk-adjusted discount rate, RADRj, for each project j:
RADRj=RF+j(rmRF)
Where:
RF = risk-free rate = 2%
Bj=beta of project j
RADRj=riskadjusted discount rate for project jrm=expected return on market portfolio = 10%
Substitute each projects beta into this equation to determine its RADR.
- Use the RADR for each project to determine its risk-adjusted NPV. Which project is preferable in this situation?
- Compare and discuss your findings in parts a and c. Which project do you recommend that the firm accept?
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