Like most firms in its? industry, Yeastime Bakeries uses a subjective risk asses
ID: 1170738 • Letter: L
Question
Like most firms in its? industry, Yeastime Bakeries uses a subjective risk assessment tool of its own design. The tool is a simple index by which projects are ranked by level of perceived risk on a scale of? 0-10. The scale is recreated in the following table.
Risk index
Required return
0
3.8 % (Current Risk-Free Rate)
1
4.3
2
4.8
3
5.3
4
5.8
5
6.3 (Current IRR)
6
6.8
7
7.3
8
7.8
9
8.3
10
8.8
The firm is analyzing two projects based on their RADRs. Project Sourdough requires an initial investment of ?$13,200 and is assigned a risk index of 5. Project Greek Salad requires an initial investment of $6,600 and is assigned a risk index of 7. The two projects have 8-year lives. Sourdough is projected to generate cash inflows of $5,400 per year. Greek Salad is projected to generate cash inflows of $3,700 per year. Use each projects RADR to select the better project.
Risk index
Required return
0
3.8 % (Current Risk-Free Rate)
1
4.3
2
4.8
3
5.3
4
5.8
5
6.3 (Current IRR)
6
6.8
7
7.3
8
7.8
9
8.3
10
8.8
Explanation / Answer
Risk-Adjusted Discount Rate, in this case, would be given by the following relationship:
Risk-Adjusted Return = Risk-Free Rate + Risk Premium
For Project Sourdough:
6.3 = 3.8 + Risk Premium
Risk Premium = 2.5 %
For Greek Salad:
7.3 = 3.8 + Risk Premium
Risk Premium = 3.5 %
As the former project has a lower risk premium as compared to the latter, the former is a better project. This is so because projects with greater risk will demand a greater risk premium. Hence, the project with the lower risk premium is less risky and better.
NPV of Sourdough = 5400 x (1/0.063) x [1-{1/(1.063)^(8)}] - 13200 = $ 19938.34
NPV of Greek Salad = 3700 x (1/0.073) x [1-{1/(1.073)^(8)}] - 6600 = $ 15239.23
The Project Sourdough is better by the NPV metric as well because it generates greater NPV.
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