Principles of Managerial Finance

a. Find the net present value (NPV) of each project using the firm’s cost of capi-

tal. Which project is preferred in this situation?

b. The firm uses the following equation to determine the risk-adjusted discount

rate, RADRj, for each project j:

RADRjRF[RIj(kRF)]

where

RFrisk-free rate of return

RIjrisk index for project j

kcost of capital

Substitute each project’s risk index into this equation to determine its RADR.

c. Use the RADR for each project to determine its risk-adjusted NPV. Which

project is preferable in this situation?

d. Compare and discuss your findings in parts aand c.Which project do you

recommend that the firm accept?

10–8 Risk-adjusted discount rates—Tabular After a careful evaluation of investment

alternatives and opportunities, Masters School Supplies has developed a CAPM-

type relationship linking a risk index to the required return (RADR), as shown

in the following table.

The firm is considering two mutually exclusive projects, A and B. The following

are the data the firm has been able to gather about the projects.

Project A Project B

Initial investment (CF 0 ) $20,000 $30,000

Project life 5 years 5 years

Annual cash inflow (CF) $7,000 $10,000

Risk index 0.2 1.4

Risk index Required return (RADR)

0.0 7.0% (risk-free rate, RF)

0.2 8.0

0.4 9.0

0.6 10.0

0.8 11.0

1.0 12.0

1.2 13.0

1.4 14.0

1.6 15.0

1.8 16.0

2.0 17.0

456 PART 3 Long-Term Investment Decisions

LG4