PV of Risk-Adjusted Cost of Capital for System A | CFA Level 1 Exam Prep

PV of Risk-Adjusted Cost of Capital for System A

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Question

The Oneonta Chemical Company is evaluating two mutually exclusive pollution control systems. Since the company's revenue stream will not be affected by the choice of control systems, the projects are being evaluated by finding the PV of each set of costs. The firm's required rate of return is 13 percent, and it adds or subtracts 3 percentage points to adjust for project risk differences. System A is judged to be a high-risk project (it might end up costing much more to operate than is expected). System A's risk-adjusted cost of capital is

Answers

A. 16 percent; since A is more risky, its cash flows should be discounted at a higher rate, because this correctly penalizes the project for its high risk.

B. indeterminate, or, more accurately, irrelevant, because for such projects we would simply select the process that meets the requirements with the lowest required investment.

C. 13 percent; the firms cost of capital should not be adjusted when evaluating outflow only projects.

D. somewhere between 10 percent and 16 percent, with the answer depending on the riskiness of the relevant inflows.

E. 10 percent; this might seem illogical at first, but it correctly adjusts for risk where outflows, rather than inflows, are being discounted.

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Explanations

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A. B. C. D. E.

k(A) = 13% - 3% = 10%. If the cash flows are cost only outflows, and the analyst wants to correctly reflect their risk, the discount rate should be adjusted downward (in this case by subtracting 3 percentage points) to make the discounted flows comparatively larger.

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