Question

What are the potential drawbacks of using a single hurdle rate to accept or reject each of a diverse set of projects?

A. The company might mistakenly accept risky projects because their NPVs are overstated.

B. The company might mistakenly reject less risky projects because their NPVs are understated.

C. Both A and B.

D. Neither A nor B

Answer 1

Please find below the solution……..let me know if you need any clarification.

Correct answer is option c) Both A and B.

Answer 2

C. Both A and B.

Using a single hurdle rate to accept or reject a diverse set of projects can lead to potential drawbacks:

A. The company might mistakenly accept risky projects because their Net Present Values (NPVs) are overstated. A single hurdle rate might not adequately account for the varying risk levels of different projects. Riskier projects may have higher expected returns, but they also carry higher uncertainty and volatility. If the single hurdle rate used is too low or does not consider the risk adequately, the company may end up accepting projects that have a higher chance of failure or lower profitability than anticipated.

B. The company might mistakenly reject less risky projects because their NPVs are understated. Conversely, if the single hurdle rate used is too high or does not differentiate based on risk, it may lead to the rejection of potentially viable projects with lower risk but still positive NPVs. These projects could contribute positively to the company's overall performance, but they are rejected due to the rigid single hurdle rate.

By using a single, uniform hurdle rate, the company may not be accurately capturing the risk-return trade-off for each project, leading to suboptimal decision-making. In reality, projects may vary significantly in their risk profiles, cash flow patterns, and potential impacts on the company's overall strategic goals. Therefore, using a one-size-fits-all approach can result in missed opportunities and inefficient allocation of resources.

Answer 3

. Both A and B.

Using a single hurdle rate (discount rate or required rate of return) to accept or reject a diverse set of projects can lead to potential drawbacks:

A. The company might mistakenly accept risky projects because their NPVs (Net Present Values) are overstated: A single hurdle rate might not adequately account for the varying risk levels of different projects. Riskier projects typically have higher uncertainty, and their cash flows may be subject to more significant fluctuations. If the same discount rate is applied to all projects, it might not accurately reflect the higher risk associated with some projects. As a result, riskier projects with potentially lower true NPVs might be accepted.

B. The company might mistakenly reject less risky projects because their NPVs are understated: Conversely, safer and less risky projects may be unfairly penalized when using a single hurdle rate. These projects tend to have more predictable cash flows and lower volatility. By applying the same discount rate to these projects as riskier ones, their NPVs might be understated. As a consequence, some worthwhile projects with higher true NPVs might be mistakenly rejected.

To avoid these drawbacks, companies often use a risk-adjusted approach by assigning different hurdle rates based on the risk profiles of individual projects. More complex and diverse projects may require specific consideration of their unique risks and opportunities, leading to a more accurate assessment of their net present values and better decision-making.