4. When analyzing potential investments, a company adjusts its cost of capital t

Question

4. When analyzing potential investments, a company adjusts its cost of capital to reflect project risk. Projects judged to be of average risk are analyzed using the company’s weighted average cost of capital, which is 11.3% per year. High risk projects are required to generate a return at least greater than the company’s cost of capital plus 2.5% per year and low risk projects must generate a return at least greater than the company’s cost of capital less 2.5% per year. Which projects should the company pursue? Project Rate of Return Risk A 10.1% Average B 13.3 High C 15.2 Low D 17.4 Average E 13.1 Low F 11.0 Average

Explanation / Answer

Project Risk type Expected return Required return Decision A Average 10.10% 11.30% Reject B High 13.30% 13.80% Reject =11.3%+2.5% C Low 15.52% 8.80% Accept =11.3%-2.5% D Average 17.40% 11.30% Accept E Low 13.10% 8.80% Accept =11.3%-2.5% F Average 11.00% 11.30% Reject

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