Question

Describe how uncertainty is calculated into cash flows. Why should two projects with equal cash flows but unequal risks produce different financial results? As a corporate financial manager (NOT as an individual person), would you prefer a low-risk, low-return project or a high-risk, high-return project, and why?

(at least 150 words)

Answer 1

Uncertainty of cash flows is denoted by the risk premium in the cost of equity which directly affects the cost of capital. A value of project is the discounted future cash flow which is discounted at the weighted average cost of capital. Two projects though having equal cash flows would have different WACC as the unequal risks put different risk premiums to the cost of equity. Cost of equity is a function of Beta and a higher risk project would have a higher beta translating into higher cost of equity. This is the reason for different value for the two projects.

As a corporate financial manager , one would prefer a high risk high return project because the equity investors typically invest in the firm for higher returns. As a corporate financial manager is an agent of shareholders, he/she will act in the best interest of the shareholders. If the shareholder is interested in low risk low return investment, he/she can consider a debt instrument or a low risk investment.