A bakery company is considering one capital budgeting project involving the repl

Question

A bakery company is considering one capital budgeting project involving the replacement of a sophisticated brick oven, and another capital budgeting project involving research and development into synthetic food substitutes. Which of the following statements is most correct concerning the risk-adjusted discount rate(s) for the projects?
Answer a. The rate will likely be higher for the replacement project because the likelihood of success is higher.
b. The rate will likely be higher for the research and development project because of the uncertainty involved with research and development projects.
c. The rate should be the same for both projects because they are being considered by one company with the same common shareholders.
d. The rate should be higher for the replacement project because the company is more certain of the returns from a project similar to their existing business.

Explanation / Answer

Generally we have two types of projects. 1. Replacement projects 2. Expansion projects The firm replace the projects generally to reduce the cots. The investment projects generally increase the revenue. Risk adjusted discount rate is the rate established by adding expected risk premium to the risk free rate. Here higher the Risk adjusted discount rate then more risk associate with the project. Such type of Projecsts we should be rejected. Therefore Option d. is correct.

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