Question

After performing a NPV on a project, your final NPV looks suspiciously high. After investigating, you realize the beta you are using is unusually low. What is a possible solution to this problem?

Answer 1

If beta of the project is lower than the project risk, expected rate of return from the project will be low. This will lead to NPV of the project being very high and project would look very attractive. Since, beta denote the risk factor, it means the risk factor associated with the project have not been factored in the required rate of return (Basic Principle: higher risk, higher return). This problem can be possibly solved by adjusting the beta to the current risk level of project. If beta is adjusted to the current risk level of the project, which in this case would be higher than the current value of beta, we will get higher expected rate of return. Calculating the NPV on the risk adjusted rate of return will provide the actual picture of the project.

We need to llok into the factors like volativity of return (by sensitivity analysis & scenario analysis). Also, one more factor impacting the beta of the project is the funding of the project. By doing a comprehensive analysis of project, actual value of beta need to be determined.