A colleague has evaluated projects using the firm\'s average discount rate, whic

Question

A colleague has evaluated projects using the firm's average discount rate, which is the discount rate on the average risk project of the firm. He produced the following report:

Project NPV IRR Risk

A (800) 9.5% Average

B (450) 10.0% Low

C $1500 12.5% High

D 0 110.0% Low

If a project has a risk that is different from average, your firm usually adjusts the discount rate by adding or substracting 2 percentage points. Suppose the four projects listed below are independent. Which project (s), you should choose and then why?

Explanation / Answer

We should choose the project C because it is the only project which has a positive NPV. When we have many investment options to choose from, we should always select the projects that have positive NPV or have a Profitability Index of more than 1 as it will increase the value of the firm.

Even though project A and B have average and low risk respectively, they have a negative NPV. An NPV of zero is better than a project which has negative NPV hence projects A and B should be obviously rejected.

Project D has zero IRR and hence would not affect the value of the firm in anyway and still has low risk. It would not make any sense to take low risk for a project that adds $0 to the value of the firm.

Hence project C is the best project to choose from among all the alternatives.

I hope my solution solves your query.

Regards.

Related Questions

Navigate

• Browse (All)
• Browse A
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.