**Unformatted text preview: **nd the risk-free rate, RF, is 10%. The firm has gathered the
following basic cash flow and risk index data for each project.
Project (j)
E
Initial investment (CF0) F G $15,000 $11,000 $19,000 Year (t) Cash inflows (CFt ) 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 0.60 456 PART 3 Long-Term Investment Decisions a. Find the net present value (NPV) of each project using the firm’s cost of capital. Which project is preferred in this situation?
b. The firm uses the following equation to determine the risk-adjusted discount
rate, RADRj, for each project j:
RADRj RF [RIj (k RF)] where
RF
RIj
k risk-free rate of return
risk index for project j
cost of capital Substitute each project’s risk index into this equation to determine its RADR.
c. Use the RADR for each project to determine its risk-adjusted NPV. Which
project is preferable in this situation?
d. Compare and discuss your findings in parts a and c. Which project do you
recommend that the firm accept?
LG4 10–8 Risk-adjusted discount rates—Tabular After a careful evaluation of investment
alternatives and opportunities, Masters School Supplies has developed a CAPMtype relationship linking a risk index to the required return (RADR), as shown
in the following table.
Risk index Required return (RADR) 0.0 7.0% (risk-free rate, RF) 0.2 8.0 0.4 9.0 0.6 10.0 0.8 11.0 1.0 12.0 1.2 13.0 1.4 14.0 1.6 15.0 1.8 16.0 2.0 17.0 The firm is considering two mutually exclusive projects, A and B. The following
are the data the firm has been able to gather about the projects.
Project A Project B Initial investment (CF0) $20,000 $30,000 Project life 5 years Annual cash inflow (CF)
Risk index $7,000
0.2 5 years
$10,000
1.4 CHAPTER 10 Risk and Refinements in Capital Budgeting 457 All the firm’s cash inflows have already been adjusted for taxes.
a. Evaluate the projects using risk-adjusted discount rates.
b. Discuss your findings in part a, and recommend the preferred project.
LG4 10–9 Risk-adjusted rat...

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