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Unformatted text preview: henever the IRR is below the cost of capital or required return (IRR k), the NPV is negative. Because by definition the IRR is the discount rate that causes NPV to equal zero and the IRR and NPV always agree on
accept–reject decisions, the relationship noted in Figure 10.2 logically follows. 436 PART 3 Long-Term Investment Decisions if the firm discounts a project’s cash inflows at too high a rate, it will reject
acceptable projects. Eventually the firm’s market price may drop, because
investors who believe that the firm is being overly conservative will sell their
stock, putting downward pressure on the firm’s market value.
Unfortunately, there is no formal mechanism for linking total project risk to
the level of required return. As a result, most firms subjectively determine the
RADR by adjusting their existing required return. They adjust it up or down
depending on whether the proposed project is more or less risky, respectively, than
the average risk of the firm. This CAPM-type of approach provides a “rough estimate” of the project risk and required return because both the project risk measure
and the linkage between risk and required return are estimates.
EXAMPLE Bennett Company wishes to use the risk-adjusted discount rate approach to
determine, according to NPV, whether to implement project A or project B. In
addition to the data presented in part A of Table 10.1, Bennett’s management
after much analysis assigned a “risk index” of 1.6 to project A and of 1.0 to project B. The risk index is merely a numerical scale used to classify project risk:
Higher index values are assigned to higher-risk projects, and vice versa. The
CAPM-type relationship used by the firm to link risk (measured by the risk
index) and the required return (RADR) is shown in the following table. Risk index Required return (RADR) 0.0 6% (risk-free rate, RF) 0.2 7 0.4 8 0.6
12 1.4 13 1.6 14 1.8 16 2.0 Project A → 10 1.2 Project B → 9 0.8 18 Because project A is riskier than project B, its RADR of 14% is greater than
project B’s 11%. The net present...
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- Fall '13