Question

1. Bloom and Co. has no debt or preferred stock ⎯ it is an all-equity firm ⎯ and has a beta of 2.0. The CFO is evaluating a project with an expected return of 14%, before any risk adjustment. The current WACC of the company is 13%. The project being evaluated is riskier than an average project, in terms of both its beta risk and its total risk. Which of the following statements is correct? Why?

1. The project should definitely be accepted because its expected return (before any risk adjustments) is greater than its required return.
2. Riskier-than-average projects should have their expected returns increased to reflect their higher risk. Clearly, this would make the project acceptable regardless of the amount of the adjustment.
3. The accept/reject decision depends on the firm's risk-adjustment policy. If Weatherall's policy is to increase the required return on a riskier-than-average project to 3% over r_S, then it should reject the project.

Answer 1

The correct statement is

c. The accept/reject decision depends on the firm's risk-adjustment policy. If Weatherall's policy is to increase the required return on a riskier-than-average project to 3% over rS, then it should reject the project.

The current WACC of the company reflects the required return on an average risk project. For higher risk project, the WACC is adjusted with risk premium and then compared with the rate of return on project.

Hence, it depends on the policy and a and b are incorrect