rj = rf+b(rm-rf) = 6% +1.5 (12% - 6%) = 15%
The project’s NPV can be computed using 15% as the discount rate:
Yr Cash flow(Le) PV at 15% PV (Le)
0 (400 0 ) 1.00 (400 0 )
1 3000 0.810 2610
2 2000 0.756 1510
3 1000 0.658 660
780
The project should be accepted since its NPV is positive, that is Le 780.
Risk (or uncertainty) refers to the variability of expected returns associated with given
investment. Risk, along with the concept of returns, is a key consideration in investment
and financing decisions.Most financial assets are not held in isolation, rather they are held as parts of portfolios.
What are important are the returns on the portfolio, not just the return on one asset, and
the portfolio risk.
Portfolio risk can be minimized by diversification, or by combining assets in an
appropriate manner. The degree to which risk is minimized depends on the correlation
between the assets being combined.Since different investment projects involve different risks, it is important to incorporate
risk into the analysis of capital budgeting, through methods like Probability distribution,
Risk adjusted discount rate, Certainty equivalent, Simulation, Sensitivity analysis, and
Decision tree (or probability trees).Through diversification, a firm can stabilize earnings, reduce risk and thereby increase
the market price of the firm’s stock.Economic value added (EVA) - measures wealth creation in a given year rather than
over the life of a project. Managers should monitor projects, make modifications, award
incentives, and impose penalties, which will continuously boost the EVA.