Question

A company is evaluating two investment project, Project A and Project B, each with different levels of risk and an initial investment of Rupees 3,00,000. The risk-free rate of return is 5% . The expected cash flows and their probabilities for each project are as follows:

Project A :
Expected cash flow in year 1 : Rs. 1,00,000
Expected Cash flow in Year 2: Rs. !,50,000
Expected Cash flow in year 3 : Rs. 2,00,000

Project B:
Expected Cash flow in year 1 : Rs. 80,000
Expected Cash flow in year 2 : Rs. 1,20,000
Expected Cash flow in year 3: Rs. 1,80,000

The company's financial analysts have determined that project A has a beta of 1.2, While Project B has a beta of 0.8 . The market risk premium is 8%.

Calculate the risk-adjusted discount rate for each project using the capital Asset pricing model (CAPM) and then determine which project the company should choose based on the risk-adjusted Net Present value (NPV) criteria.

Answer 1

Using the formula: Risk-adjusted discount rate = Risk-free rate + Beta * Market risk premium.

The risk-adjusted discount rate for Project A is 0.164 and for Project B is 0.116.

The company should choose Project B as it has a higher risk-adjusted NPV.

Step-by-step explanation:

To calculate the risk-adjusted discount rate for each project using the CAPM, we need to use the formula:

Risk-adjusted discount rate = Risk-free rate + Beta * Market risk premium

For Project A:

Risk-adjusted discount rate for Project A = 0.05 + 1.2 * 0.08

= 0.164

For Project B:

Risk-adjusted discount rate for Project B = 0.05 + 0.8 * 0.08

= 0.116

To determine which project the company should choose based on the risk-adjusted net present value (NPV), we need to calculate the NPV for each project.

For Project A:

NPV for Project A = (1,00,000 / (1 + 0.164)^1) + (1,50,000 / (1 + 0.164)^2) + (2,00,000 / (1 + 0.164)^3) - 3,00,000

= 31,883.75

For Project B:

NPV for Project B = (80,000 / (1 + 0.116)^1) + (1,20,000 / (1 + 0.116)^2) + (1,80,000 / (1 + 0.116)^3) - 3,00,000

= 1,38,149.80

Based on the risk-adjusted NPV criteria, the company should choose Project B as it has a higher NPV.