7. Within-firm risk and beta risk Aa Aa Understanding risks that affect projects

Question

7. Within-firm risk and beta risk Aa Aa Understanding risks that affect projects and the impact of risk consideration wSp Inc. is involved in a wide range of unrelated projects. The company will pursue any project that it thinks will create value for its stockholders. Consequently, the risk level of the company's projects tends to vary a great deal from project to project. Ir WSP Inc. does not risk-adjust its discount rate for specific projects properly, which of the folowing is likely to occur over time? Check all that apply The firm wil become less risky. The firm will make poor capital budgeting decisions that could jeopardize the long-run viability of the company The firm will reject too many relatively safe projects. Generaly, a positive correlation exists between a project's returns and the returns on the firm's other assets. If this correlation is , stand-alone risk will be a good proxy for within-firm risk. high low Consider the case of another company. Davis Printing is evaluating two mutually exclusive projects. They both require a $5 milion investment today and have expected NPVs of $1,000,000. Management conducted a full risk analysis of these two projects, and the results are shown below. Risk Measure Standard deviation of project's expected Npvs Project beta Project A Project B $400,000 $600,000 1.2 Correlation coefficient of project cash flows (relative to tha firm's existing projects) 0.7 1.0 0.9 Which of the following statements about these projects risk is correct? Check all that apply

Explanation / Answer

Answer 1   Option b and c

If the firm is not adjusting its discount rate for riskof specific projects than it would end up accepting risky projects by dicounting them at a lower rate as well as it would lose less risky projects by discounting them at a higher rate, as it is using single discount rate for all the projects. This would jeoprodize the long run viability of the firm as well.

Answer 2 : High Corelation

WIth high positive corelation between the return on project and return on other assets of the firm. The stand alone risk would be good proxy for within firm risk, as high positive corelation would mean that the impact on the firms returns and the projects return would be similar for the change in risk factors to a high degree and both have similar risk.

Answer 3 Option d (i.e. Project A has more market risk than project b)

The reason being that project A has a higher beta than project b.

option a is not correct because of the same reason above

option b is not correct because project b has higher positive corelation with other exsisting projects of the firm thus project b has higher corporate risk not project a

option c is not correct because project a has less standard deviation than project b which would imply project b having hgher stand alone risk than Project a

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