Like most firms in its industry, Yeastime Bakeries uses a subjective risk assessment tool of its own design. The tool is a simple index by which projects are ranked by level of perceived risk on a scale of 0-10. The scale is recreated in the following table.
Risk index Required return0 ..... 4.0% (current risk-free rate)
1 .............. 4.5
2 .............. 5.0
3 .............. 5.5
4 .............. 6.0
5 .......... 6.5 (current IRR)
6 .............. 7.0
7 .............. 7.5
8 .............. 8.0
9 ............. 8.5
10 .............. 9.0
The firm is analyzing two projects based on their RADRs. Project Sourdough requires an initial investment of $12,500 and is assigned a risk index of 6. Project Greek Salad requires an initial investment of $7,500 and is assigned a risk index of 8. The two projects have 7-year lives. Sourdough is projected to generate cash inflows of $5,500 per year. Greek Salad is projected to generate cash inflows of $4,000 per year. Use each project's RADR to select the better project.