Which of the following statements is correct? Assume that the firm is a publicly owned corporation and is seeking to maximize shareholder wealth.
Project A has a standard deviation of expected returns of 20%, while Project B’s standard deviation is only 10%. A’s returns are negatively correlated with both the firm’s other assets and the returns on most stocks in the economy, while B’s returns are positively correlated. Therefore, Project A is less risky to a firm and should be evaluated with a lower cost of capital.
If a firm’s managers want to maximize the value of the stock, they should, in theory, concentrate on project risk as measured by the standard deviation of the project’s expected future cash flows.
If a firm has a beta that is less than 1.0, say 0.9, this would suggest that the expected returns on its assets are negatively correlated with the returns on most other firms’ assets.
If a firm evaluates all projects using the same cost of capital, and the CAPM is used to help determine that cost, then its risk as measured by beta will probably decline over time.