Question

Yatta Net International has manufacturing, distribution, retail, and consulting divisions. Projects undertaken by the manufacturing and distribution divisions tend to be low-risk projects, because these divisions are well established and have predictable demand. The company started its retail and consulting divisions within the last year, and it is unknown if these divisions will be profitable. The company knew that opening these new divisions would be risky, but its management believes the divisions have the potential to be extremely profitable under favorable market conditions. The company is currently using its WACC to evaluate new projects for all divisions.

If Yatta Net International 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 increase in value.

The firm could potentially reject projects that provide a higher rate of return than the company should require.

The firm’s overall risk level will increase.

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

Consider the case of another company. Chrome Printing is evaluating two mutually exclusive projects. They both require a $1 million investment today and have expected NPVs of $200,000. 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	$80,000	$120,000
Project beta	0.9	0.7
Correlation coefficient of project cash flows (relative to the firm’s existing projects)	0.6	0.8

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

Project B has more market risk than Project A.

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

Project B has more corporate risk than Project A.

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

Answer 1

1).If the company does not risk adjust its discount rate for specific projects then:

-- The firm could end up rejecting projects that provide a higher rate of return than the company should require.

-- Also, over a period of time, the firm’s overall risk level will increase as it will accept projects which it should not and reject projects which it should accept.

2). 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. (A high correlation indicates that returns of the project and other assets move in tandem, so both will be affected to approximately the same degree by risk.)

3). These two statements are correct:

-- Project B has higher corporate risk than Project A (as it has higher correlation with the firm's other projects)

-- Project B has more stand-alone risk than Project A (as it has higher standard deviation of expected NPV than project A)