Question

wansley enterprises is considering a new project. the company has a beta of 1.0, and its sales and profits are positively correlated with the overall economy. the company estimates that the proposed new project would have a higher standard deviation and coefficient of variation than an average company project. also, the new project's sales would be countercyclical in the sense that they would be high when the overall economy is down and low when the overall economy is strong. on the basis of this information, which of the following statements is correct? a. the proposed new project would increase the firm's corporate risk. b. the proposed new project would not affect the firm's risk at all. c. the proposed new project would have less stand-alone risk than the firm's typical project. d. the proposed new project would increase the firm's market risk. e. the proposed new project would have more stand-alone risk than the firm's typical project.

Answer 1

The proposed new project would have more stand-alone risk than the firm's typical project due to its higher standard deviation and coefficient of variation, despite its countercyclical sales pattern.

Step-by-step explanation:

When assessing a new project's impact on a company's risk, there are a few types of risk to consider. Corporate risk pertains to the risks that affect the firm's overall earnings variability. Market risk is associated with the volatility in a company's stock price in relation to the overall market, often measured by beta. A firm's beta of 1.0 indicates that its stock price has historically moved with the market.

Given that Wansley Enterprises already has a beta of 1.0, its financial performance is positively correlated with the economy. However, the proposed new project has a countercyclical sales pattern, meaning its sales would be higher when the economy is down and lower when the economy is strong.

This dynamic could potentially stabilize the company’s earnings throughout different economic cycles, reducing the firm's corporate risk. However, the new project is described as having a higher standard deviation and coefficient of variation, which indicates higher stand-alone risk compared to the firm's typical project.

Therefore, the correct answer to the student's question is 'e. the proposed new project would have more stand-alone risk than the firm's typical project', because it has a higher standard deviation and coefficient of variation, notwithstanding its countercyclical nature.