1. Jennifer uses the discounted payback method to evaluate any project that cost

Question

1. Jennifer uses the discounted payback method to evaluate any project that costs less than $1 million. Applying the discounted payback decision rule to all projects is most likely to cause:

Some positive net present value projects to be rejected.

2. Melinda has two investments: a risk-free asset and the market portfolio. She has graphed both investments' expected return as a function of each investments' beta. The slope of the line connecting the two dots represents the:

Beta coefficient

Market beta

3. Tyler is concerned about his portfiolio so he asks his best friend Tippie for some advice. Since Tippie is a certified financial advisor, he is most likely to counsel Tyler that:

1. Jennifer uses the discounted payback method to evaluate any project that costs less than $1 million. Applying the discounted payback decision rule to all projects is most likely to cause:

Explanation / Answer

Question 1 - Some positive net present value projects to be rejected.

A discounted payback period method if used as a decision making tool may lead to ignoring cash flows that occur after achieveing discounted payback. This may actually lead us to accept project with a negative NPV or reject projects with positive NPV, both of which would be detrimental to firm's value.

Question 2 - Market Risk Premium

The graph where the expected return is plotted against the beta is basically the security market line. Security market line is graphical representation of CAPM equation. In this SML, the x-axis represents beta, y-axis represents expected return, intercept on y-axis is the risk free rate and slope is market risk premium.

Question 3 - Spreading an investment across many diverse assets will eliminate some of the total risk.

Diversification across assets or asset classes does not have any impact on systematic risk which is also called as undiversifiable risk or market risk.

Diversification however reduced unsystematic risk, which is the risk specific to an investment. Total risk = Systematic risk + Unsystematic risk.

Since diversification reduces or eliminates unsystematic risk, total risk also reduces. Remember, we cannot reduce systematic risk and hence we also cannot eliminate the total risk.

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