Laramie Labs uses a risk-adjustment when evaluating projects of different risk.
ID: 2774098 • Letter: L
Question
Laramie Labs uses a risk-adjustment when evaluating projects of different risk. Its overall (composite) WACC is 10%, which reflects the cost of capital for its average asset. Its assets vary widely in risk, and Laramie evaluates low-risk projects with a WACC of 8%, average-risk projects at 10%, and high-risk projects at 12%. The company is considering the following projects:
Project
Risk
Expected Return
A
High
15%
B
Average
12%
C
High
11%
D
Low
9%
E
Low
6%
Which set of projects would maximize shareholder wealth?
A and B.
A, B, and C.
A, B, and D.
A, B, C, and D.
A, B, C, D, and E.
Project
Risk
Expected Return
A
High
15%
B
Average
12%
C
High
11%
D
Low
9%
E
Low
6%
Explanation / Answer
To determine which project (s) will maximize shareholder's wealth, we will have to compare the expected return with the WACC (for different types of projects) and select those projects which have expected return higher than the WACC/required return.
Project A, B and D (which is Option C) should be accepted to maximize shareholder's wealth.
Project Risk Expected Return Required Return (WACC) Accept/Reject Reason A High 15% 12% Accept Expected Return is more than Required Return B Average 12% 10% Accept Expected Return is more than Required Return C High 11% 12% Reject Expected Return is less than Required Return D Low 9% 8% Accept Expected Return is more than Required Return E Low 6% 8% Reject Expected Return is less than Required ReturnRelated Questions
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