3 questions Quiz 11: Ch 12- Cash Flow Estimation and Risk Analysis 5. Within-fir

Question

3 questions Quiz 11: Ch 12- Cash Flow Estimation and Risk Analysis 5. Within-firm risk and beta risk Understanding risks that affect projects and the impact of risk consideration Garcia Real Estate is involved in commercial real estate ventures throughout the United States. Some of these ventures are much riskier than other ventures because of market conditions in different regions of the country. If Garcia does not risk-adjust its discount rate for specific ventures properly, which of the following is likely to occur over time? Check all that apply. The firm will become less valuable. The firm will accept too many relatively safe projects The firm will accept too many relatively risky projects. How do managers typically deal with within-firm risk and beta risk when they are evaluating a potential project? O Quantitatively O Subjectively Consider the case of another company. Davis Printing is evaluating two mutually exclusive projects. They both require a $3 million investment today and have expected NPVs of $600,000. Management conducted a full risk analysis of these two projects, and the results are shown below. Project A Project B $240,000 $360,000 Risk Measure Standard deviation of project's expected NPVs Project beta Correlation coefficient of project cash flows (relative to the firm's existing projects) 1.2 1.4 0. 0.s Which of the following statements about these projects' risk is correct? Check all that apply. Project A has more market risk than Project B. Project B has more market risk than Project A. Project A has more stand-alone risk than Project B.

Explanation / Answer

1. The answe is C, Firm will accept too many risky projects

If the discount rate is not adjusted for risk then its value will be less than what it should be.

Having smaller discount rate, the NPV of the project become higher and we will end up accepting projects which ideally are more risky and should be avoided.

2.

The managers deal with within the firm risk and beta risk subjectively. Since it is the risk which is within the firm, managers tries to look for the qualitative aspects and not quatantitative

3. Answer is A, Project A has more market risk than B

Beta = correlation (assets and market ) * standard deviation of asset / standard deviation of market

Project A

Beta = 1.2

Standard devaition of asset = 240,000

correlation = 0.7

So standard deviation of market = 0.7 * 240,000 / 1.2 = 140,000

Project B

Beta = 1.4

Standard devaition of asset = 360,000

correlation = 0.5

So standard deviation of market = 0.5 * 360,000 / 1.4 = 128,571

So Project A has more market risk than project B

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