Question

Consider the case of United Recycling Inc.:

United Recycling Inc. is one of the largest recyclers of glass and paper products in the United States. The company is looking into expanding into the cardboard recycling business. The company’s CFO has performed a detailed analysis of the proposed expansion.

The company’s CFO used sophisticated software to analyze a large number of scenarios and generate estimated rates of return and risk indexes.

Based on the information given, determine which of the statements is correct.

A. The company’s CFO conducted a sensitivity analysis to evaluate the project’s financial model.

B. The company’s CFO used a Monte Carlo simulation to evaluate the project’s financial model.

Evaluating risk is an important part of the capital budgeting process. Which of the following is measured by the variability of the project’s expected returns?

A. Market, or beta, risk

B. Stand-alone risk

C. Corporate, or within-firm, risk

_______________ is measured by the project’s impact on uncertainty regarding the firm’s future returns.

A. Market risk

B. Stand-alone risk

C. Corporate, or within-firm, risk

D. Risk-adjusted cost of capital

Answer 1

The correct statement is B. The company’s CFO used a Monte Carlo simulation to evaluate the project’s financial model.

Sensitivity analysis is done usually by excel spreadsheet. it has limitation for large number of scenarios and becomes complicated and error-prone for large number of scenarios with too much time consuming.

A sophisticated software like Monte Carlo simulation can do this analysis with very large number of scenarios with less amount of time and error-free if input data are correct.

The correct answer is B. Stand-alone risk.

Stand-alone risk is measured by the variability of the project’s expected returns. stand-along risk is the risk which will have impact only on a particular project or asset's returns.

Market or beta, risk is the risk which will affect the entire market.

Corporate, or within-firm, risk is the risk which will affect a particular firm's returns for all the projects and assets firm has.

The correct answer is D. Risk-adjusted cost of capital.

Risk-adjusted cost of capital is measured by the project’s impact on uncertainty regarding the firm’s future returns. If a project of a firm is riskier than other projects of the firm then that particular project's cost of capital is risk-adjusted. risk-adjusted means the cost of capital of that project will be higher than cost of capital for other projects because that particular project has higher risk.

rest all of the risks have been explained in part 2.