Yatta Net Internation 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 predicitible demand. The compnay started its retail and consulting divisions within the last year, and it is unknown if these divisions will be profitable. The compnay 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 compnay is currently using its WACC to evaluate new projects for all divisions.
1. 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.
a. The firm's overall risk level will increase
b. The firm could potentially reject projects that provide a higher rate of return than the compnay should require
c. The firm will increase in value
2. When a project involves an entirely new product like, the firm may be able to obtain betas from (a. the firm's previous projects, b. pure-play companies in the new area) to calculate a weighted average cost of capital (WACC) for its new product line.
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 MeasureProject AProject B
Standard deviation of project's expected NPVs$80,000$120,000
Project beta1.21.4
Correlation coefficient of project cash flows (relative to the firm;s existing projects)
0.6
0.8
3. Which of the following statements about these projects' risk is correct? Check all that apply.
a. Project A has more market risk than Project B
b. Project B has more stand-alone risk than Project A
c. Project A has more corporate risk than Project B
d. Project B has more market risk than Project A
Answers: 1
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