Question

A firm is considering the purchase of an asset whose risk is greater than the current risk of the firm, based on any method for assessing risk. In evaluating this asset, the decision maker should
a) Increase the IRR of the asset to reflect the greater risk.
b) Increase the NPV of the asset to reflect the greater risk.
c) Reject the asset, since its acceptance would increase the risk of the firm.
d) Ignore the risk differential if the asset to be accepted would comprise only a small fraction of the total assets of the firm.
e) Increase the required rate of return used to evaluate the project to reflect the higher risk of the project.

Answer 1

Answer:

e) Increase the required rate of return used to evaluate the project to reflect the higher risk of the project

Explanation:

As per the basic concept of investment, "higher the risk, higher the return".

Thus, an investor assumes a higher risk only in the scenario wherein the expected return would be commensurate with such risk. Investor would only invest in a risky asset when the return derived can compensate him for the excess risk assumed.

Required rate of return is an investors expectation of return from a project also referred to as the cost of capital.

So for the purpose of evaluating the project, the investor should use a higher required rate of return to signify higher risk which would reveal the true viability of the project.