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Risk-adjusted discount rates

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A firm is considering investing in one of the three mutually exclusive projects E, F, G. The firms cost of capital, r, is 15% and the risk-free rate, Rf, is 10%. The firm gathered the basic cash flow and risk index data for the project, as shown below.

Initial Investment CF0 E $15,000 F $11,000 G$19,000
Year 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

A.) Find the net present value of each project using the firms 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 x (r-Rf)]

C.) Use the RADR for each project to determine its risk adjusted NPV. Which project is preferable in this situation?

D.) Compare the finding in part a. and c. Which project do you recommend that the firm accept?

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Solution Summary

The risk-adjusted discount rates are determined.

Solution provided by:
Jayant Kumar, MBA
Education
  • MBA, Indian Institute of Finance
  • Bsc, Madras University
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