Question

If an all-equity firm discounts a project's cash flows with the firm's overall weighted average cost of capital even though the project's beta is less than the firm's overall beta, it is possible that the project might be:A. accepted, when it should be rejectedB. rejected, as it should beC. accepted, as it should beD. rejected, when it should be accepted

Answer 1

Answer:

D. rejected, when it should be accepted

Explanation:

The first thing to understand in this question is ''what is beta''? Beta is a measure of risk in a company or in a particular project. Sometimes a company wants to take on a project that is not in its normal line of business, hence the risk of that project will differ from the risk of the company. If the risk of the project is higher (project beta) than the company's risk (company beta) and you judge the project based on the company risk (beta), you will be setting yourself up for a fall because you'll accept the project when you should have rejected it. Contrariwise, if the project beta (risk) is lower than the company's beta (risk), and you judge it with the company's risk - you are judging the project with a higher risk than it has and it could make the company reject the project when it should have been accepted.