Question

Understanding risks that affect projects and the impact of risk consideration Garcia Real Estate is involved in commercial real estate ventures throughout the United States. Some of these ventures are much riskier than other ventures because of market conditions in different regions of the country If Garcia does not risk-adjust its discount rate for specific ventures properly, which of the following is likely to occur over time? Check all that apply The firm will reject too many relatively safe projects The firm will become less risky The firm will make poor capital budgeting decisions that could jeopardize the long-run viability of the company 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. Davis Printing is evaluating two mutually exclusive projects. They both require a $3 milion 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 Standard deviation of project's expected NPVs Project beta Correlation coefficient of project cash flows (relative to the firm's existing projects) Project A Project B $240,000 $120,000 0.9 0.7 0.5 Which of the following statements about these projects' risk is correct? Check all that apply Project B has more stand-alone risk than Project A. Project A has more stand-alone risk than Project B Project A has more market risk than Project B Project A has more corporate risk than ProjectB

Answer 1

1: Options 1 and 3

If the discount rate is not risk adjusted, the risky projects will be selected since they have higher cash flows. The result is that the safer projects will be rejected and overall risk will increase.

2: High

If the correlation between project returns and returns of firms assets is high stand alone risk can be used instead of within firm risk

3: Options 2 and 3

Project A has more standalone risk (Since CV is higher)

Project B has more corporate risk (Since beta is higher)

Project A has more market risk (Since SD is higher)