Question

A college intern working at Anderson Paints evaluated potential investments using the firm’s average required rate of return (r) as the discount rate in the evaluation process and he produced the following report for you as the capital budgeting manager at Anderson Paints:

                                                   Project              NPV                 IRR              Risk

                                                   LOM           $1,500                 12.5%          High

                                                   QUE                      0                 11.0              Low

                                                   YUP                (800)               10.0           Average

                                                   DOG               (150)                  9.5              Low

As the capital investment manager you must account for the risks associated with capital budgeting projects before making final recommendations and decisions. The company’s capital investment risk management policy calls for an adjustment of the firm’s average required rate of return by plus/minus 2% if a project’s risk deviates from the firm’s average risk classification. The table above shows the estimated profitability of each project using the average required rate of return of the company and disregarding any deviation of each project’s risk from the firm’s average.

Your job as the capital investment manager is to account for differences in risk in each project according to company’s policy and to make recommendations regarding the acceptability or non-acceptability of each potential investment as part of the upcoming proposed firm’s capital budget. First, explain how you would adjust each project’s required rate of return for risk using the risk management policy of the company and discuss the appropriateness of the firm’s risk management policy. Second, insert a column in the table above showing the appropriate risk-adjusted required rate of return or discount rate for each project. Third, explain which of the projects listed above you would recommend and why for the upcoming firm’s capital investment budget..

Answer 1

The firm's average return can be estimated from the QUE project which has a zero NPV using the firm hurdle rate. Since, IRR = 11%, so firm return equals 11%, as well.

The project's return is then adjusted +/- 2% depending on its classification, as shown below:

NPV @11% 1500 Project LOM QUE YUP DOG IRR 12.50% 11.00% 10.00% 9.50% Risk High Low Average Low Project return (Firm return +/- 2%) 13.00% 9.00% 11.00% 9.00% -800 -150

Adjusting each project return on the basis of its risk is sound capital budgeting policy and will help in realistically evaluating the feasibility of each project.

As can be seen from the table, projects YUP and LOM are rejected because its IRR is less than the required return. Additionally, project LPM will have negative NPV at 13% discount rate. Project QUE can be accepted as its IRR is higher than the required return of 9%. Also, it will have a positive NPV at 9% discount rate. Project DOG's IRR is also greater than its required return and will have a positive NPV at 9% discount rate so it is also acceptable. In summary, both low risk projects are acceptable.