Yatta Net International has manufacturing, distribution, retail, and consulting divisions. Projects undertaken by the manufacturing and distribution divisions tend to be low-risk projects, because these divisions are well established and have predictable demand. The company started its retail and consulting divisions within the last year, and it is unknown if these divisions will be profitable. The company knew that opening these new divisions would be risky, but its management believes the divisions have the potential to be extremely profitable under favorable market conditions. The company is currently using its WACC to evaluate new projects for all divisions.
1) If Yatta Net International does not risk-adjust its discount rate for specific projects properly, which of the following is likely to occur over time? Check all that apply.
The firm will become less valuable.
The firm will accept too many relatively safe projects.
The firm will accept too many relatively risky projects.
2) Generally, a positive correlation exists between a project’s returns and the returns on the firm’s other assets. If this correlation is (High/Low)?, stand-alone risk will be a good proxy for within-firm risk.
Consider the case of another company. Kim Printing is evaluating two mutually exclusive projects. They both require a $1 million investment today and have expected NPVs of $200,000. Management conducted a full risk analysis of these two projects, and the results are shown below.
|
Risk Measure |
Project A |
Project B |
|---|---|---|
| Standard deviation of project’s expected NPVs | $80,000 | $120,000 |
| Project beta | 1.2 | 1.0 |
| Correlation coefficient of project cash flows (relative to the firm’s existing projects) | 0.7 | 0.5 |
3) Which of the following statements about these projects’ risk is correct? Check all that apply.
Project B has more stand-alone risk than Project A.
Project A has more market risk than Project B.
Project A has more corporate risk than Project B.
Project A has more stand-alone risk than Project B.
1) The firm should actually risk-adjust its discount rate for specific projects. the reason being that if it start taking WACC as the discount rate and doesn't take into account the project specific risks it will start accepting very risky projects. hence the correct option is c.
2) Yes a positive correlation does exist between a project's return and return from other assets. if the correlation is high then the standalone risk can be a good proxy for within firm risk but not if the correlation is low.
3) Project B has a higher SD than Project A implying a higher stand-alone risk .
Project A has a beta of 1.2 while project B has a beta 1 which implies that Project A has a higher risk than project B.
Project B has a lower correlation wrt the firm's cashflow than project A implying a higher corporate risk for Project B.
Hence the correct options are (a),(b).
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