Question

Weatherall Enterprises has no debt or preferred stock¾it is an all-equity firm¾and has a beta of 2.0. The chief financial officer is evaluating a project with an expected return of 14%, before any risk adjustment. The risk-free rate is 5%, and the market risk premium is 4%. The project being evaluated is riskier than an average project, in terms of both its beta risk and its total risk. Which of the following statements is CORRECT?
A.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.
B.Capital budgeting projects should be evaluated solely on the basis of their total risk. Thus, insufficient information has been provided to make the accept/reject decision.
C.The accept/reject decision depends on the firm's risk-adjustment policy. If Weatherall's policy is to increase the required return on a riskier-than-average project to 3% over rS, then it should reject the project.
D.The project should definitely be accepted because its expected return (before any risk adjustments) is greater than its required return.
E.The project should definitely be rejected because its expected return (before risk adjustment) is less than its required retu

Answer 1

Answer:

The accept/reject decision depends on the firm's risk-adjustment policy. If Weatherall's policy is to increase the required return on a riskier-than-average project to 3% over rS, then it should reject the project - option C

Explanation:

Once the said project is riskier, the accept/ reject criterion will be considered based on risk adjusted discount rate which would be higher than company’s cost of capital by the amount of risk premium. Here the risk premium is 3%.

Thus, the decision to accept/reject depends on the risk-adjustment policy of the firm. If Weatherall's policy is to increase the required return on a riskier-than-average project to 3% over rS, then it should reject the project - option C is the best answer.