Dick Boe Enterprises, an all-equity firm, has a corporate beta coefficient of 1.5. The financial manager is evaluating a project with an IRR of 21 percent, before any risk adjustment. The risk-free rate is 10 percent, and the required rate of return on the market is 16 percent. The project being evaluated is riskier than Boe's average project, in terms of both beta risk and total risk. Which of the following statements is most correct?
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A. B. C. D. E.Explanation
k(s) = 10% + (16% - 10%)1.5 = 10% + 9% = 19%.
Original IRR = 21%. 21% - Risk adjustment 1% = 20%.
Risk adjusted IRR = 20% > k(s) = 19%.
To determine the correct answer, let's analyze the given information:
Corporate beta coefficient: Dick Boe Enterprises has a corporate beta coefficient of 1.5. The beta coefficient measures the sensitivity of an investment's returns to changes in the overall market. A beta greater than 1 indicates higher volatility or risk compared to the market.
Project's IRR: The project being evaluated has an internal rate of return (IRR) of 21 percent before any risk adjustment. The IRR is the discount rate that makes the net present value (NPV) of the project's cash flows equal to zero. It is a measure of the project's profitability.
Risk-free rate and required rate of return: The risk-free rate is given as 10 percent, representing the return on a risk-free investment. The required rate of return on the market is stated as 16 percent. This is the minimum rate of return investors expect to earn given the level of risk in the market.
Project's riskiness: The project is described as riskier than Boe's average project in terms of both beta risk and total risk. This means that the project has a higher level of systematic risk (measured by beta) and overall risk compared to the average project undertaken by the firm.
Now let's analyze each statement and determine which one is most correct:
A. Riskier-than-average projects should have their IRRs increased to reflect their added riskiness. Clearly, this would make the project acceptable regardless of the amount of the adjustment. This statement suggests that the project's IRR should be increased to reflect its added riskiness. However, increasing the IRR is not a common practice or a risk adjustment method. Adjusting the IRR upward would make the project more attractive, but it is not a standard approach. Additionally, the statement does not consider the required rate of return or other factors.
B. The accept/reject decision depends on the risk-adjustment policy of the firm. If the firm's policy were to reduce a riskier-than-average project's IRR by 1 percentage point, then the project should be accepted. This statement acknowledges that the accept/reject decision depends on the firm's risk-adjustment policy. It proposes a specific risk-adjustment method of reducing the project's IRR by 1 percentage point due to its riskier nature. If the firm follows this policy, the project should be accepted. This statement takes into account the required rate of return and suggests a specific risk-adjustment approach.
C. The project should be accepted since its IRR (before risk adjustment) is greater than its required return. This statement only considers the project's IRR before any risk adjustment and compares it to the required rate of return. It fails to consider the project's riskiness and the need for risk adjustment. Without considering risk adjustment, it is not possible to conclude that the project should be accepted based solely on the IRR exceeding the required return.
D. The project should be rejected since its IRR (before risk adjustment) is less than its required return. Similar to option C, this statement only compares the project's IRR to the required rate of return without considering risk adjustment. Without incorporating the project's riskiness and the need for risk adjustment, it is not appropriate to reject the project solely based on the IRR being less than the required return.
E. Projects should be evaluated on the basis of their total risk alone. Thus, there is insufficient information in the problem to make an accept/reject decision. This statement suggests that projects should be evaluated based solely on their total risk without considering other factors. It concludes that there is insufficient information to make an accept/reject decision. However, in practice, projects are typically evaluated based on both risk and return, considering