Question

Polycorp is investigating two projects. The risk-free rate is 5% pa and the market premium is 6%pa. Project A has a beta of .7 and Project B has beta of 1.8. The projects are independent. If accepted the projects will initially be funded by borrowing at 7%pa. The relevant net cash flows for each project are below. The firm's current weighted average cost of capital is 11% pa (before taking either or both A and B). Assume no taxes. Calculate the NPV of each project and indicate which project or projects should be accepted/rejected. Explain your choice of the discount rate and your adjustment for risk.

Year 0 1 2

A (10000) 5300 7400

B (15000) 8700 9500

Answer 1

One should use risk adjusted discount rates and not the weighted average cost of capital to fully account for the risk of the project

Using CAPM Risk adjusted discount rate=risk free rate+beta*market risk premium

Project A=5%+0.7*6%=9.200%

Project B=5%+1.8*6%=15.800%

NPV of Project A=-10000+5300/1.092+7400/1.092^2=1059.117927

NPV of Project B=-15000+8700/1.158+9500/1.158^2=-402.5909719

Project A should be accepted as NPV is positive

Project B should be rejected as NPV is negative