Question

Understanding risks that affect projects and the impact of risk consideration

WSP Inc. is involved in a wide range of unrelated projects. The company will pursue any project that it thinks will create value for its stockholders. Consequently, the risk level of the company’s projects tends to vary a great deal from project to project.

If WSP Inc. does not risk-adjust its discount rate for specific projects properly, which of the following is likely to occur over time? Check all that apply.

The firm will accept too many relatively risky projects.

The firm will become less valuable.

The firm will accept too many relatively safe projects.

Generally, a positive correlation exists between a project’s returns and the returns on the firm’s other assets. If this correlation is _______, stand-alone risk will be a good proxy for within-firm risk.

Consider the case of another company. Kim Printing is evaluating two mutually exclusive projects. They both require a $3 million investment today and have expected NPVs of $600,000. Management conducted a full risk analysis of these two projects, and the results are shown below.

Risk Measure	Project A	Project B
Standard deviation of project’s expected NPVs	$240,000	$360,000
Project beta	0.9	0.7
Correlation coefficient of project cash flows (relative to the firm’s existing projects)	0.7	0.5

Which of the following statements about these projects’ risk is correct? Check all that apply.

Project A has more corporate risk than Project B.

Project B has more corporate risk than Project A.

Project A has more market risk than Project B.

Project B has more stand-alone risk than Project A.

Answer 1

If WSP Inc. does not risk-adjust its discount rate for specific projects properly, the following will likely to occur over time

• The firm will accept too many relatively risky projects.
• The firm will become less valuable.

Generally, a positive correlation exists between a project’s returns and the returns on the firm’s other assets. If this correlation is “HIGH” stand-alone risk will be a good proxy for within-firm risk.

Project A has more corporate risk than Project B.

Project B has more stand-alone risk than Project A.

Project A has more market risk than Project B.

(1)- Correlation coefficient of project cash flows of Project-A is higher than the Project-B, therefore, the Project A has more corporate risk than Project B.

(2)- Standard deviation of project’s expected NPVs of Project-B is higher than the Project-A, therefore, the Project B has more stand-alone risk than Project A.

(3)-The Beta of the Project-A is higher than the Project-B, therefore, the Project A has more market risk than Project B