6. Within-firm risk and beta risk Aa Aa Understanding risks that affect projects
ID: 2781872 • Letter: 6
Question
6. Within-firm risk and beta risk Aa Aa Understanding risks that affect projects and the impact of risk consideration WSP Inc. is involved in a wide range of unrelated projects. The company will pursue any project that it thinks will create value for its stockholders. Consequently, the risk level of the company's projects tends to vary a great deal from project to project. If WSP Inc. does not risk-adjust its discount rate for specific projects properly, which of the following is likely to occur o ver time? Check all that apply The firm will become less risky The firm will make poor capital budgeting decisions that could jeopardize the long-run viability of the company The firm will reject too many relatively safe projects. How do managers typically deal with within-firm risk and beta risk when they are evaluating a potential project? O Subjectively O Quantitatively 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) 1.2 0.7 Which of the following statements about these projects' risk is correct? Check all that apply Project B has more stand-alone risk than Project A Project A has more stand-alone risk than Project B Project B has more market risk than Project A Project A has more market risk than Project BExplanation / Answer
Option 1,2&3
Option 1
Option 2,3
If it does not risk-adjust discount rate it would discard less risky projects and would choose more risky projects as 1) less risky projects should be evaluated using lower cost of capital but as the firm is applying higher cost of capital, it would be discarded and 2) more risky projects should be evaluated using higher cost of capital but as the firm is applying lower cost of capital, it would be accepted..Hence, the firm will become risky
Managers subjectively deal with within-firm risk and beta risk.
Standalone risk is measured by standard deviation..Higher the standard deviation higher is the standalone risk. So, Project A has more standalone risk than Project B
Market risk is measured by beta. Higher the beta higher is the market risk. So, Project B has higher market risk than Project A
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