A firm is considering two mutually exclusive projects, A and B. The projects are
different in that they have different returns depending on general economic conditions. The
firm forecasts that return on the market, and the returns on each project, along with their
associated probabilities will be given by the following table. You can assume a 5% risk free
rate and a 6% market risk premium. Assume the CAPM holds. Compare the expected
returns to the cost of capital for each project and decide which project the firm should choose.
Extreme Recession
Moderate Recession
Normal
Moderate Growth
Extreme Growth
Pr[economic condition]
15%
20%
30%
20%
15%
Return on the market
-12%
0%
12%
24%
36%
Return on project A
-35%
2%
10%
20%
20%
Return on project B
-9%
0%
12%
22%
28%
COST OF CAPITAL FOR PROJECT A ACROSS CONDITIONS =
COST OF CAPITAL FOR PROJECT B ACROSS CONDITIONS =
Which project should firm choose and why?
A firm is considering two mutually exclusive projects, A and B. The projects are
different in that they have different returns depending on general economic conditions. The
firm forecasts that return on the market, and the returns on each project, along with their
associated probabilities will be given by the following table. You can assume a 5% risk free
rate and a 6% market risk premium. Assume the CAPM holds. Compare the expected
returns to the cost of capital for each project and decide which project the firm should choose.
Extreme Recession
Moderate Recession
Normal
Moderate Growth
Extreme Growth
Pr[economic condition]
15%
20%
30%
20%
15%
Return on the market
-12%
0%
12%
24%
36%
Return on project A
-35%
2%
10%
20%
20%
Return on project B
-9%
0%
12%
22%
28%
COST OF CAPITAL FOR PROJECT A ACROSS CONDITIONS =
COST OF CAPITAL FOR PROJECT B ACROSS CONDITIONS =
Which project should firm choose and why?
Related questions
You are considering two mutually exclusive projects with the following cash flows. The appropriate cost of capital for Project A is 10%. The appropriate cost of capital for Project B is 14%. Find the Profitability Index and Payback Period of each project. Make sure to show your work.
| Year 0 | Year 1 | Year 2 | Year 3 | |
| Project A | -$1,000 | $500 | $600 | $700 |
| Project B | -$10 | $10 | $20 | $30 |
Country Wallpapers is considering investing in one of three mutually exclusive projects, E, F, and G. The firmâs cost of capital, r, is 15%, and the risk free rate, Rf, is 10%. The firm has gathered the basic cash flow and risk index data for each project as shown in the following table.
| Project (j) | |||
| E | F | G | |
| Initial Investment (CF0) | -$15,000 | -$11,000 | -$19,000 |
| Year (t) | Cash Inflows | ||
| 1 | $6,000 | $6,000 | $4,000 |
| 2 | 6,000 | 4,000 | 6,000 |
| 3 | 6,000 | 5,000 | 8,000 |
| 4 | 6,000 | 2.000 | 12,000 |
| Risk index (RIj) | 1.80 | 1.00 | 0.60 |
Find the net present value (NPV) of each project using the firmâs cost of capital. Which project is preferred in this situation?
The firm uses the following equation to determine the risk-adjusted discount rate, RADR, for each project j: RADRj=Rf + [RIj x (r-Rf)]
Where: Rf=risk free rate of return
RIj=risk index for project j
r=cost of capital
Substitute each projectâs risk index into this equation to determine its RADR.
Use the RADR for each project to determine its risk-adjusted NPV. Which project is preferable in this situation?
Compare and discuss your finding in part a and c. Which project do you recommend that the firm accept?Country Wallpapers is considering investing in one of three mutually exclusive projects, E, F, and G. The firmâs cost of capital, r, is 15%, and the risk free rate, Rf, is 10%. The firm has gathered the basic cash flow and risk index data for each project as shown in the following table.
| Project (j) | |||
| E | F | G | |
| Initial Investment (CF0) | -$15,000 | -$11,000 | -$19,000 |
| Year (t) | Cash Inflows | ||
| 1 | $6,000 | $6,000 | $4,000 |
| 2 | 6,000 | 4,000 | 6,000 |
| 3 | 6,000 | 5,000 | 8,000 |
| 4 | 6,000 | 2.000 | 12,000 |
| Risk index (RIj) | 1.80 | 1.00 | 0.60 |
Find the net present value (NPV) of each project using the firmâs cost of capital. Which project is preferred in this situation?
The firm uses the following equation to determine the risk-adjusted discount rate, RADR, for each project j: RADRj=Rf + [RIj x (r-Rf)]
Where: Rf=risk free rate of return
RIj=risk index for project j
r=cost of capital
Substitute each projectâs risk index into this equation to determine its RADR.
Use the RADR for each project to determine its risk-adjusted NPV. Which project is preferable in this situation?
Compare and discuss your finding in part a and c. Which project do you recommend that the firm accept?
p12-8 using excel
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