When a project involves an entirely new product line, the firm may be able to ob

Question

When a project involves an entirely new product line, the firm may be able to obtain betas from the firm's previous projects pure-play companies in the new area the firm's previous projects to calculate a weighted average cost of capital (WACC) for its new product Consider the case of another company. Davis 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) 0.9 1.1 0.7 0.5 Which of the following statements about these projects' risk is correct? Check all that apply. ? Project B has more corporate risk than Project A. Project A has more corporate risk than Project B. ? Project B has more stand-alone risk than Project A. Project A has more market risk than Project B

Explanation / Answer

QUESTION 1

When entering a new product line, company may be able to obtain betas from PURE PLAY COMPANIES IN NEW ARER to calculate the WACC for new product. This is because the existing Beta/WACC of the firm firstly, will not account for the risk associated with this new product. Second, beta of existing firm would be weighted towards risk of the existing lines of business that may over or underweight the risk involved with the new product and hence lead to incorrect valuation of WACC.

QUESTION2

Standard deviation measures standalone risk and beta measures market risk or corporate risk. Standard deviation of A is higher, this implies Project A has higher standalone risk. However, Beta is higher for Project B and hence it carries higher corporate risk. So looking at these the correct statements are:

Project B has more corporate risk than project A

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