Garcia Real Estate is involved in commercial real estate ventures throughout the
ID: 2798174 • Letter: G
Question
Garcia Real Estate is involved in commercial real estate ventures throughout the United States. Some of these ventures are much riskier than other ventures because of market conditions in different regions of the country If Garcia does not risk-adjust its discount rate for specific ventures properly, which of the following is likely to occur over time? Check all that apply. The firm will become less risky The firm will reject too many relatively safe projects. The firm will make poor capital budgeting decisions that could jeopardize the long-run viability of the company Generally, 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 Consider the case of another company. Turnkey Printing is evaluating two mutually exclusive projects. They both require a $5 million 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. Project A Project B $400,000 $200,000 Risk Measure Standard deviation of project's expected NPVs Project beta Correlation coefficient of project cash flows (relative to the firm's existing projects) 1.2 0.7 0.9Explanation / Answer
1. Answer: The firm will make poor capital budgeting decisions.
This is because while using a risk adjusted discount rate, a company basically takes into consideration the risk factor of a project. That is, the required rate should be compensation for investing the money plus compensation for risk borme by undertaking the project. It is only logical because if the risk involved is higher, the project should yield higher returns.
The other two options are eliminated because not using RADR is unlikely to make the firm less risky and an unadjusted rate will not lead to rejection of relatively safe projects.
2. If the correlation is +1, stand alone risk will be a good proxy for within firm risk.
A correlation of +1, implies, that the stand alone risk will mirror within firm risk. That is, if the returns of the project will fall by 10%, within firm returns will also fall by 10% and vice versa. Thus, stand alone risk can be used as a proxy for within firm risk.
3. Project A has more market risk than Project B : True since the Beta of A is higher than Beta of B and market movements will affect returns of A more.
Project A has more stand alone risk than B: True because standard deviation of A is higher than B
Project A has more corporate risk than Project B: False because correlation coefficient of A is lower than that of B. In such a case movement in the return of other firm assets will have a lower effect in movement of A's returns thus bringing down the corporate risk.
Project B has more market risk than Project A: False because beta of B is lower than beta of A
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