Question

10-20 The CFO of Bogey Golf has been given the following information about two mutually exclusive investments: Project X Y IRR 14.0% 19.0 Risk Average High The CFO normally uses a risk-adjusted required rate of return to evaluate such investments. The firm's average required rate of return, which is 15 percent, is adjusted by 5 percent for high-risk projects, and it is adjusted by 3 percent for low-risk projects. Which project(s) should Bogey purchase?

Answer 1

Solution:

Average Required Rate of Return = 15%

Risk Adjusted Rate of Return for High Risk Project = Average Required Rate of Return + Adjustment in Rate for High Risk Project

= 15% + 5%

= 20%

Risk Adjusted Rate of Return for Low Risk Project = Average Required Rate of Return + Adjustment in Rate for Low Risk Project

= 15% + 3%

= 18%

Risk Adjusted Rate of Return for Average Risk Project = Average Required Rate of Return + Adjustment in Rate for Average Risk Project

= 15% + 4%

= 19%

Project X

IRR of the Project is less than Risk adjusted rate of return as the risk involved is Average

14% < 19%

Therefor project cannot be accepted

Project Y

IRR of the Project is less than Risk adjusted rate of return as the risk involved is High

19% < 20%

Therefor project cannot be accepted

Both the Projects cannot be accepted