1. If a firm uses a single source of capital to fund a project, which of the following is correct?
The average cost of all previously raised capital should be used for evaluation.
Only the cost of that source should be used to evaluate the project.
This project should still be evaluated using the firm’s WACC.
Book values of the funding source should be used in calculating WACC.
2. Nelson Enterprises, an all-equity firm, has a beta of 2.0. Nelson’s chief financial officer is evaluating a project with an expected return of 21%, before any risk adjustment. The risk-free rate is 7%, and the market risk premium is 6%. The project being evaluated is riskier than Nelson’s average project, in terms of both its beta risk and its total risk. Which of the following statements is correct?
Riskier-than-average projects should have their expected returns increased to reflect their higher risk. Clearly, this would make the project acceptable regardless of the amount of the adjustment.
The accept/reject decision depends on the firm’s risk-adjustment policy. If Nelson’s policy is to increase the required return on a riskier-than-average project to 3% over rS, then it should reject the project.
The project should definitely be accepted because its expected return (before any risk adjustments) is greater than its required return.
The project should definitely be rejected because its expected return (before risk adjustmenT) is less than its required return.