Nico Manufacturing is considering investment in one of two mutually exclusive pr

Question

Nico Manufacturing is considering investment in one of two mutually exclusive projects X and Y which are described below. Nico Manufacturing's overall cost of capital is 15 percent, the market return is 15 percent and the risk-free rate is 5 percent. Nico estimates that the beta for project X is 1.20 and the beta for project Y is 1.40.

                                   Project X           Project Y

Initial Investment            $3,500,000         $3,900,000           

Year                                 Cash Inflows (CF)

    1                               $1,500,000         $1,100,000

     2                                1,500,000           1,600,000

     3                               1,500,000           1,900,000

    4                                 1,500,000           2,300,000   

----Calculate the risk-adjusted discount rates for Project X and Project Y.

Explanation / Answer

Risk adjusted discount rate = Rf+×Rp

Risk adjusted discount rate for X:

= 5%+1.2×(15%-5%)

= 17%

Risk adjusted discount rate for Y:

= 5%+1.4×(15%-5%)

= 19%

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