Asked by Hilary Sahagun on May 27, 2024
Verified
Nelson Enterprises,an all-equity firm,has a beta of 2.0.Nelson's chief financial officer is evaluating a project with an expected return of 21%,before any risk adjustment.The risk-free rate is 7%,and the market risk premium is 6%.The project being evaluated is riskier than Nelson's average project,in terms of both its beta risk and its total risk.Which of the following statements is correct?
A) The project should definitely be accepted because its expected return (before any risk adjustments) is greater than its required return.
B) The project should definitely be rejected because its expected return (before risk adjustments) is less than its required return.
C) Riskier-than-average projects should have their expected returns increased to reflect their higher risk. Clearly, this would make the project acceptable regardless of the amount of the adjustment.
D) The accept/reject decision depends on the firm's risk-adjustment policy. If Nelson's policy is to increase the required return on a riskier-than-average project to 3% over rS, then it should reject the project.
Risk Premium
A risk premium is the additional return expected by an investor for taking on a higher level of risk, compared to a risk-free investment.
Expected Return
The average return anticipated on an investment based on its historical or probable future earnings.
Market Risk Premium
The additional return expected by investors for holding a risky market portfolio instead of risk-free assets.
- Identify and calculate a firm's cost of capital using various models such as the CAPM.
- Analyze the effect of project-specific risks on the cost of capital and the importance of adjusting the WACC for different risk profiles.
Verified Answer
KD
Kerri DeansMay 30, 2024
Final Answer :
D
Explanation :
The accept/reject decision for the project depends on the firm's risk-adjustment policy. Since the project is riskier than Nelson's average project, the required return should be higher than the risk-free rate plus the market risk premium (i.e., 13%). If Nelson's risk-adjustment policy is to increase the required return on a riskier-than-average project to 3% over rS (i.e., 16%), then the project should be rejected because its expected return of 21% is less than the required return of 16%. Therefore, option D is the correct choice.
Learning Objectives
- Identify and calculate a firm's cost of capital using various models such as the CAPM.
- Analyze the effect of project-specific risks on the cost of capital and the importance of adjusting the WACC for different risk profiles.